By Danilo Masoni and Helen Reid
MILAN/LONDON (Reuters) - The third-quarter reporting season kicks off this week with European companies on track for a second year of solid profit growth, but investors are shunning them even though valuations have not been this cheap since the euro zone crisis.
As a result, European companies cannot afford to disappoint market expectations if they want to attract investors back to a region they have spurned in favour of Wall Street.
European equities have been a painful trade this year, as political turmoil and the region's vulnerability to trade risks starkly contrasted with the allure of tax cuts, stock buybacks and a booming economy in the United States.
Even a developing stock market rout in the United States and Europe this week hit Europe harder, taking the S&P 500 (SPX) - fresh from record highs - to its lowest in just three months while the pan-European STOXX 600 (STOXX) benchmark hit a 21-month low.
"There's good reason to expect European growth is going to remain solid going forward but the U.S. is still going to be leading the global cycle," Richard Turnill, global chief investment strategist at BlackRock, said.
(Europe's valuation gap back to euro zone crisis levels: https://reut.rs/2OhiUUY)
"Overall the outlook is somewhat weaker [for Europe]. It's roughly half what we expect from the U.S. over the next twelve months. And geopolitical risks are likely to be a continued overhang for European stocks," he added.
Wall Street's biggest banks formally kick off the results season on Friday.
Overall according to IBES Refinitiv, third-quarter company earnings in Europe are expected to have increased 14 percent year-on-year, against the 21.4 percent growth expected for the S&P 500.
Europe's main equity index (STOXX) hit its lowest level since December 2016 on Thursday, bringing its underperformance versus the S&P 500 (SPX) this year to 11.7 percent.
(European earning revisions turn negative: https://reut.rs/2OfJUnQ)
That has sunk European equity valuations to extreme levels. The discount to U.S. stocks is nearing 20 percent - a gap last seen during the 2009-2012 sovereign debt crisis which prompted hefty monetary policy easing in the euro zone.
Being cheap has not been enough to attract inflows, though.
After being a popular global trade in 2017 the tide has rapidly turned for European equities on the back of economic and earnings disappointments.
As Britain's Brexit deadline nears and Italy seeks to loosen fiscal discipline, investors have pulled money out of European equity funds in 25 weeks out of the past 30, according to the latest figures from U.S.-based fund tracker EPFR Global.
"A lot of money has flowed out of European equities and I think that most investors are now waiting on the sidelines for confirmation that the situation is improving," Pierre Bose, head of European Strategy, International Wealth Management at Credit Suisse (SIX:CSGN) in Zurich, said.
"For the over-allocation that you had to European equities at the end of last year you haven't been rewarded. You have withdrawn that positioning and haven't got an incentive at the moment to allocate to Europe away from other regions," he added.
(CESI October 11: https://reut.rs/2Ogtwnf )
"THAT MAKES INVESTORS NERVOUS"
The gloomy outlook on Europe's trade-sensitive economy and fragmented politics has clouded the view on earnings.
Even though European earnings are expected to rise 8 percent this year after growing 12 percent in 2017, over the last few weeks analysts' earnings downgrades have outnumbered upgrades.
"That makes investors a bit nervous," Christian Stocker, equity strategist at UniCredit in Munich, said.
"This normally heralds some pressure and for the next few quarters I expect a significant slowdown in earnings growth for the euro zone," he added.
Against this backdrop, European companies' valuation multiples are unlikely to increase any time soon, at least until Brexit, Italy and trade war clouds are cleared.
To be sure, some investors are confident companies can deliver enough to push prices back up.
"We expect some deal as far as Brexit is concerned, and that the Italian situation will sort itself out, and the gap in Economic Surprise Index versus the US suggests the numbers posted in Europe should be relatively good," Charles de Boissezon, deputy head of global asset allocation and equity strategy at Societe Generale (PA:SOGN) in Paris, said.
Citi's economic surprise index for the euro zone has risen since June, an indication economists are beginning to up their expectations for the bloc, while the U.S. index has fallen.
VALUATION STRESS DRIVES EARNINGS FOCUS
While investors recoil from cheap autos and banking stocks, highly-valued luxury and tech sectors no longer seem to be a safe place to hide. That was clear this week when luxury stocks sank and Europe's tech sector (SX8P) had its worst day since the Brexit vote, while in the U.S. the tech-heavy Nasdaq had its biggest fall in seven years.
Europe's dearth of tech - the engine of the global rally - has hurt it on the up but could provide helpful insulation in a selloff focusing on the most expensive parts of the market.
The renewed focus on valuations suggests any recovery in European stocks hinges on companies' ability to deliver strong earnings. Any disappointment is likely to cause a bigger dent than the boost from positive surprises.
"Given all the uncertainty from Italy and trade tensions I do not expect we have room for (valuation) multiple expansion," UniCredit's Stocker said. "The remaining potential for the European equity market is still earnings growth."
Credit Suisse's Bose said it was unlikely that European stocks would be able to offset the macro headwinds over the next four to six weeks as they report their earnings updates.
"I think what people will be looking for is ... just for companies to match expectations," he said.
(Reporting and graphics by Danilo Masoni and Helen Reid. Additional reporting by Julien Ponthus. Editing by Jane Merriman)