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A recent correction in European stocks due to the strength of the euro is a buying opportunity for investors, according to a new report from Barclays.
The research states that the 5 percent decline in European stocks driven by the 10 percent appreciation in the euro may appear justified. The pan-European Stoxx 600 hit a two-year high in May but saw losses as risk sentiment turned sour on geopolitical tensions. The index is down nearly 5 percent over the last three months.
"In theory, a 10 percent strengthening in the euro/usd should see a 5 percent cut to year-end earnings per share forecasts, thereby justifying the aforementioned 5 percent stock market decline," the report states, adding, that in practice, no change has been made to the bank's year-end EPS (earnings per share) growth forecast from the strengthening of the currency. EPS is the portion of a company's profit allocated to each outstanding share of common stock.
The euro is currently trading at $1.19 against the dollar, after hitting a two-and-a-half year high on the back of a weaker dollar and on political risks easing in the euro zone. The common currency is up nearly 14 percent since the start of the year and some analysts had warned that a stronger euro could knock a few percent off earnings.
In a recent report, UBS analysts wrote that a 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 (the first quarter of) 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 last month.
While a stronger euro is a concern for exporters as it makes their products more expensive and less attractive, analysts at Barclays are not worried due to better economic growth in the region.
"The reason why a stronger euro does not impact on our 2017 EPS growth forecast lies in the driver of euro strength - better economic growth," the Barclays report noted.
The research underlines that many analysts believe a strengthening euro cannot provide positive returns for those investing in European stock markets, but it argues that this may not necessarily be the case. The directionality of stock market returns and the currency has been mostly positive, particularly pre-quantitative easing, Barclays noted.
"The impact on 2017 earnings from the stronger currency is offset by the upgrades to growth forecasts. This leaves us forecasting 10 percent earnings growth, and without price-to-earnings multiple expansion, 10 percent returns from the stock market." The price-to-earnings ratio is an important metric used by traders to value a company by measuring its current share price relative to its earnings.
Barclays further added that with the market already up around 4 percent this year, the Euro Stoxx 600 target suggests a further 6 percent potential upside for the index.
European companies reported a 25 percent profit growth in the first quarter of 2017. Stocks in Europe hit a two-year high in May as investors ditched their positions from the U.S. into a more politically-certain Europe.
"For the first time in several years, European equity earnings are increasing throughout the course of this year rather than decreasing and the biggest technical argument for that is the fact that 60 billion euros ($72.29 billion) exited European equities in the past two years, 20 billion euros ($24.09 billion) of that are back in, there's still 40 billion euros ($48.18 billion) waiting on the sidelines," Nandini Ramakrishnan, global market strategist at JPMorgan Asset Management, told CNBC last month, crediting the bank's own in-house research.