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With the euro on the rise against major world currencies, investors may be concerned about how this will weigh on European profits and some analysts suggest the stronger euro could knock up to 3 percent off earnings.
"If currencies stay stable, we think (the trade-weighted euro) will peak out up around 6 percent year-on-year in Q1 2018, meaning around 2 to 3 percentage points off earnings per share (EPS) growth," said Nick Nelson, Karen Olney and Joao Toniato, strategists for UBS in an equity strategy note published Thursday.
The euro is up 12 percent year-to-date against the dollar and 7.5 percent against sterling. A stronger currency makes products more expensive for foreign buyers, which is bad news for exporters and reduces earnings.
However, the UBS report says the 3 percent knock to earnings is not disastrous as euro zone company earnings are up strongly this year.
"Additionally, there have been periods in the past of euro strength coinciding with decent European eps as it can signal a stronger domestic economy. Consensus estimates for 2017 EPS growth, currently 12.8 percent, have been remarkably steady year-to-date," the strategists said.
The euro has accumulated so much this year because of improving economic growth, receding political risks and election results in the Netherlands and France that appealed to the markets, according to Jaisal Pastakia, investment manager at Heartwood Investment Management.
"Contrast this train of improving events with the U.K., where economic momentum looks uncertain. Monthly factory orders this year suggest that the sector is failing to capitalize from a weaker sterling and a pick-up in global trade. In addition, political uncertainty is likely to continue to weigh on the UK currency," he said in a note.
"The euro's fortunes this year are also at odds with the U.S. dollar. Positioning in the U.S. dollar reflects investors' pessimism about the ability of the Trump administration to make progress on its legislative agenda, particularly on tax reform."
Another impact of the stronger currency is that it may push the European Central Bank consider scaling back monetary stimulus more gradually, according to Morgan Stanley economists.
"The central bank has recently expressed some concerns about a possible currency overshoot. To the extent that FX strength is caused by capital inflows, which are in turn caused by economic strength, it's not necessarily negative," said Daniele Antonucci and Joao Almeida, economists at Morgan Stanley, in a research note published Wednesday.
"But a sustained euro appreciation will likely exert a negative effect on growth and inflation."
One way to play the stronger euro is to invest in domestically exposed sectors, as these are less impacted by currency fluctuations impacting their earnings.
The UBS report suggests the real estate, utilities and banking sectors are the most domestically exposed sectors which are also enjoying earnings upgrades compared to the rest of the market.
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