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In Europe, Earnings' Surprising Strength

By Clive McDonnell From Standard & Poor's European MarketScope

Consensus earnings forecasts for the S&P Europe 350 have increased from 9.4% at the start of the year to 17% today.

The primary sectors responsible for the increase include energy, healthcare, telecoms, and transport. The increase in earnings forecasts has helped keep a lid on valuations which have risen from 12.5 times forecast 2005 earnings at the start of the year to 13.5 times today.

Looking ahead, a key issue for investors is the sustainability of analysts' forecasts for 2006, which at this early stage in the cycle stand at 8.4%.

CORPORATE INGENUITY. Even if analysts had second sight and could see where the oil price was heading, none -- aside from energy -- would have forecast corporate earnings to expand as rapidly as they have. Plug in a 40% average annual increase in the cost of oil into most economic models and the outcome is a recession as opposed to continued expansion.

The same can be said for corporate earnings in terms of the impact of rising input prices on margins. However, as the rally in the market attests, the reality has been quite different.

How do things look for 2006? Return on equity (RoE) is forecast to increase to 15% from 14% this year as corporate margins remain intact and the banking sector continues to swim as opposed to sink. Clearly, corporate management has found ways to mitigate the negative effect of rising input prices on margins.

WATCHING OIL. The issue of the sustainability of forecast earnings growth in 2006 is a pertinent one. Note that this forecast is roughly the same as the number for 2005 pencilled in by analysts this time last year. However, we doubt the result for 2006 will be for earnings growth more than double initial expectations. The key swing factors are oil and interest rates. If there is no respite from high oil prices, corporations will struggle to find even more efficiency gains to offset rising input prices.

Additionally, if interest rates rise sooner than expected in the euro zone, bank earnings are likely to come under pressure as the recovery in bank lending and wholesale banking activity tapers off.

McDonnell is European equity strategist for Standard & Poor's

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