By Lucy Raitano and Samuel Indyk

LONDON (Reuters)

Europe's third-quarter earnings have mostly exceeded low market expectations, rewarding investors who are favoring companies that beat forecasts, despite warnings from weak Chinese demand.

In the two months before the start of Europe's earnings season, analysts downgraded their earnings growth estimates by approximately 380 basis points, according to LSEG I/B/E/S data, setting a lower threshold for companies. Typically, analysts adjust their growth forecasts down by about 100 bps prior to earnings season.

So far, around 50% of the STOXX 600 has reported results, with approximately 56% of these companies surpassing expectations, aligning with the average quarterly result.

As the U.S. gears up for elections on Tuesday, this uncertainty may lead to continued volatility in European share trading.

Five Lessons from Europe's Q3 Earnings Season

Earnings Beats Rewarded

Contrary to previous quarters, companies that beat expectations have been better rewarded, while those that missed forecasts have faced less punishment.

Bank of America Global Research's analysis found that stocks exceeding expectations outperformed the market by an average of 1.8% on their earnings announcement day, marking the second strongest performance in a decade. In contrast, companies that missed EPS underperformed by 0.8%, staying within historical norms.

Andreas Bruckner, BofA equity strategist, noted that pre-reporting concerns about Q3 earnings appeared exaggerated, as actual earnings results provided positive surprises. Moreover, consensus EPS for Q3 has recently been revised up by 3%.

China Weakness Hits Cyclicals

Although earnings beats are being rewarded, the slowdown in China's economy has negatively impacted Europe's cyclical stocks. Companies across sectors are facing lower demand due to concerns about the world's second-largest economy.

Graham Secker, head of equity strategy at Pictet Wealth Management, expressed that earnings revisions are widespread, but Europe is experiencing a more severe decline, especially in China-dependent sectors like automotive.

Luxury brands like LVMH and automakers such as Mercedes-Benz and Volkswagen, along with energy company BP, have all indicated that weak Chinese activity has influenced their results.

China Stimulus Offers Glimmer of Hope

Despite challenges and their effects on Q3 results, there remains a cautious optimism for a rebound in Chinese demand following recently announced aggressive stimulus measures aimed at economic support by Chinese authorities.

Bernie Ahkong, CIO Global Multi-Strategy Alpha at hedge fund UBS O'Connor, acknowledged the downbeat sentiment around near-term Chinese demand but suggested that European stocks are reacting more favorably to earnings compared to actual financial outcomes and forecasts.

Banks Riding Interest Rate Wave

Europe's banks enjoyed another strong quarter, supported by persistently high interest rates enhancing their margins. While the European Central Bank may lower borrowing costs, investor sentiment remains optimistic.

RBC Wealth Management's Thomas McGarrity emphasized that interest rates are likely to stay structurally higher than in previous cycles, providing beneficial conditions for banks. Earnings growth for financials in Q3 is estimated at 20.6%, ranking as the third highest among Europe's major sectors, with 80% of these companies beating earnings expectations.

Weak Growth Outlook Provides Small Opportunities

Europe's economy has largely stagnated over the past two years, with the industrial sector heavily affected by rising energy costs and weak global demand. Major corporations may have global operations, but domestic demand is adversely affecting small- and mid-cap earnings, leaving the outlook fragile.

Marlborough fund manager David Walton mentioned that expectations have been downgraded, speculating recovery timelines to be post-2025, creating a chance to invest in undervalued firms. European corporations remain historically low-priced, with 12-month forward earnings trading averaging 13.6x compared to the long-term average of 14.3x; mid-caps are at 12.7x against a long-term average of 15x.

(This article has been refiled to correct the omission of the word 'earnings' in the headline.)