Rising costs, poor demand squeeze key Europe sectors

FRANKFURT (Reuters) - Shares in European industrials, chemicals and airline groups are set to stay under pressure for the rest of the year as input prices rise and demand for products and services remains depressed.

Oil racked up the highest quarterly gain since 1990 in the second quarter, rallying 42 percent. So far this year, prices of key industrial inputs copper and nickel have risen 58 and 33 percent respectively, while steelmakers have raised prices this month.

The rise in raw materials has been driven by the prospect of an uptick in the global economy but this optimism has not fed through to selling prices for companies' products.

Producer prices for goods from companies such as ABB (ABBN.VX) dropped 4.6 percent in April, and the International Air Transport Association has forecast losses of $9 billion (5.5 billion pounds) this year for the about 200 airlines it represents.

"Pricing power remains very low -- if you want to keep your market share you cannot charge your customers more," said Robert Griffiths, an equity strategist at Cazenove in London.

"Towards the end of the year might be a good time to look at shares again that are under pressure now, as investors are likely to be careful until they see a pickup in demand in Europe," he said.

Stocks of the European travel and leisure industry .SXTP and chemical companies .SX4P -- sectors dependent on oil, as a fuel and the basis for inputs -- are little changed on the year so far, in sharp contrast with mining .SXPP, up 36 percent, and banks .SX7P, up 19 percent.

Engineers Siemens (SIEGn.DE) and Finmeccanica (SIFI.MI) have fallen by around 10 percent each this year, underperforming a 3.7 percent rise in the broader market .STOXX.

While the rate at which companies can raise prices has fallen, there is pressure on other fronts as well: unit labour cost growth has accelerated year-on-year, equity strategists from Nomura pointed out.

"Euro area firms were adding to staff numbers as recently as the second quarter 2008 and have been relatively slow to trim headcount as the economy slowed," they said in a note.

Falling incomes are also set to hit consumer demand. The European Central Bank predicts wages to decline "significantly" this year in the private sector. Price growth in the euro zone in June for the first time ever was negative and the ECB says consumer prices will fall for a couple of months.

In the auto sector rising raw material costs are adding to the burden from existing overcapacity globally. Nissan (7201.T) recently offered the highest customer cash rebate ever, according to research from the University Duisburg-Essen.

"Orders have shrunk so rapidly that companies had to play by their customers' rules when it came to pricing," said Simon Britta, engineering sector analyst at Julius Baer in Zurich.

"The later the economic recovery, the greater the pressure on margins will be."

MORE PRESSURE TO COME

A 10 percent increase in the oil price would cost Lufthansa (LHAG.DE) 100 million euros (86 million pounds) this year and some 200 million euros next year and would lead the airline to post an operating loss in 2009, Bankhaus Metzler analyst Juergen Pieper estimated.

Steel companies such as ThyssenKrupp (TKAG.DE) sell most of their steel in contracts with a duration of more than three months, so that price increases can only be effected once current contracts expire, suggesting some of the squeeze is still to come.

The sector's customers are feeling the pressure. German bottling machine maker Krones (KRNG.DE) said that bottling machinery suppliers are undercutting one another in price, leading the company to warn it might post a loss this year.

The head of Siemens' industrial solutions unit told German paper Frankfurter Allgemeine Zeitung that the decline in prices for the units' services was still continuing.

Rising crude is hitting chemicals companies as oil is the basis for most of their products.

"Even if raw material prices were not to rise, margins are coming under pressure," said UniCredit analyst Andreas Heine, who focuses on chemicals.

"That'll surely be the case this year and next," he said.

In March, Bayer BAYG.DE, one of the world's largest plastics makers, lowered its profit expectations for this year and said in June that even the new target, a declined of operating profit by 5 percent, will be hard to reach.

Companies might be able to escape the squeeze on profitability if markets pick up and sales volumes rise to an extent that they make up for lower margins.

Equity markets would follow soaring commodity markets if economic growth returns in the second half of the year, and the current lack of pricing power is just a natural first phase of the cycle, say market participants who predict a quick recovery.

"From a story of Armageddon we are now moving to a prospect of cyclical recovery," said Mislav Matejka, European equity strategist at JPMorgan.

"We are predicting an upturn in the second half of the year, when volume increase will be dominating input costs."

But the ECB recently appeared to push back timing of a recovery, with its president, Jean-Claude Trichet saying economic activity would remain weak for the rest of the year.

Although recent data suggested the breakneck pace of decline may be slowing, stabilisation of the economy would begin only next year, he added.

(With reporting by Paul Carrel in Berlin, Angelika Gruber, Peter Starck and Sakari Suoninen in Frankfurt, Rebekah Curtis in London)

(Editing by Sitaraman Shankar)