Debt burdens driving down valuations

The recently released estimates for GDP for 2011 Q1 indicate increasing divergence between Germany, France, and the other successful northern economies, on the one hand, and the peripheral economies – Portugal, Ireland, Greece and Spain – plus Italy, on the other.

German’s GDP grew by 1.5 per cent, exceeding expectations, boosted by falling unemployment and strong global demand for its industrial exports. The news prompted Philipp Rösler, Germany’s new economics minister, to say: “Germany is the growth motor among the industrial nations – and not just in Europe.”

While the French economy expanded by 1 per cent, growth in Spain and Italy remained sluggish with first-quarter GDP rising by just 0.3 per cent and 0.1 per cent. The UK economy, which has been particularly affected by the banking crisis, was stagnant with zero growth over the past 2 quarters.

Portugal fell back into recession with GDP contracting by a further 0.7 per cent. Greece, which is supposedly on the verge of default despite having already received a E110bn ($155bn) international bailout last year, saw its GDP grow 0.8 per cent, after contracting sharply for the past four consecutive quarters.

BAILOUTS

EU finance ministers have approved a three year, E78bn bailout for Portugal, which follows Greece and Ireland in seeking emergency loans from the European Union and the International Monetary Fund, bringing the aid provided to stamp out the sovereign debt crisis to E256bn.

“We are seeing this two-speed economy in Europe, where peripheral countries struggle under very high debt burdens and high levels of unemployment, and will likely continue to do so for many years, while core nations, most notably Germany, are going from strength to strength,” says Brian O’Reilly, head of wealth management research UK, at UBS.

But what is the impact of this heterogeneous economic situation on the stockmarket? Year to date, European equities are up 4 per cent in euro-denominated terms. The German Dax stock index has increased by 5 per cent, but Spanish stocks are up 6.5 per cent. Even Ireland posted 5 per cent returns, although Greece is struggling (-6 per cent), according to MSCI data.

“The mistake that investors often make is to extrapolate economic data and draw a straight line through to equity markets. But equities are all about valuation. The market has actually discounted quite a lot of the negative sentiment in Europe,” says Mr O’Reilly.

The European market is trading at just over 10 times forward earnings, which is still about 25 per cent below historical averages. “A lot of the bad news is already in the price, and we continue to see very good earnings particularly from strong export-oriented companies focused in Asia,” he says. Dividend yields are also very favourable, in excess of 3 per cent compared to 2 per cent available in the US.

“If we were to single out one country, it would have to be Germany.”

There are two key reasons for investing there, says Mr O’Reilly: the first is its strong export-led recovery – almost 50 per cent of German GDP comes from exports, driven by exposure to Asia in particular, with many high tech manufacturing companies producing components which are increasingly in demand there. The second is a pick up in German consumer demand, fuelled by low level of unemployment, currently at 7.6 per cent, the lowest in over a decade, leading to increased business and consumer confidence.

The state of emerging countries’ economies has a remarkable impact on the decision to allocate more or less to European equities. If emerging markets have been the darling of the investment world since the March 2009 lows, the winds are now changing. Inflation is a growing problem for many of these markets; central banks are tightening their monetary policy in both Asia and Latin America, which is slowing down growth and higher interest rates have a negative impact on stockmarket performance.

“The long-term structural story in emerging markets remains very much in place and it is important that investors do not lose sight of the long-term need and requirement to be invested in emerging markets, although in the near term there may be some underperformance, as investors get nervous around the end of QE2 in the US,” says Mr O’Reilly, explaining the valuation case is, however, more compelling today than it was towards the autumn of last year.

INFLATION WORRIES

Jörg Zeuner, chief economist at VP Bank Group in Liechtenstein believes the immediate macro-economic challenges in emerging markets are larger than in Europe, as far as impact on the stockmarkets goes. “This is why, in the shorter term, in the next three to six months, we are more in favour of Europe, together with the US.”

The preference for European stocks depends on a number of factors. “One aspect we look at is inflation, particularly the commodity price inflation in emerging markets, the response of the local central banks to it and how much it will slow down growth in the emerging markets. Once we have a better sense of that, which we expect is going to be sometime in the second half of the year, then we will reassess whether or not Europe is still a favourable region compared to others.”

In addition to the strategic allocation to those European companies having big exposure to the domestic growth story of Asia, mainly large caps – such as Unilever, Mercedes Daimles, Volkswagen or companies in the discretionary consumptions space, such as Adidas – the call today is for stocks that benefit from German growth, such as Siemens, BASF or Allianz, says Mr Zeuner.

“There is evidence that the financial sector is normalising and, at the same time, in the bond markets, the default ratios are decling, creating an environment favourable for banks, which are now beginning to lend.”

Moreover, investment banking might profit from the growth in M&A activity.

“In terms of valuations, the financial sector was left behind. It was one of the worst performing sectors in 2010, and we believe there is potential for it to catch up, in this environment.”

The one overriding theme to overlay in all sectors is pricing power. Last year’s hike in commodity prices has highlighted the importance of a company’s pricing power and their ability to protect their margins. In that respect, corporates operating in the business to business segment, which can pass onto their clients the higher prices more easily, prove the most attractive. Firms in the business to consumer sector are likely to encounter greater difficulties, as consumers are still trying to repair their balance sheets in the aftermath of the financial crisis.

The one segment of the world that has overcome the crisis extremely well is the corporate sector, says Mr O’Reilly at UBS. “We estimate cash on balance sheets is the highest it has been over 50 years. Industries specifically focused on business to business, such as some of the technology companies should continue to do well,” he says.

The potential impact of the currency movements on earnings is also important to watch, explains Eric Le Coz, a member of the investment committee at Carmignac Gestion. “Currency volatility is always something penalising a company’s earnings one way or the other. For example, if you invest in a company that has a large exposure to the US, then you take the risk of the slowdown in the US economy and the risk of weakening of the US dollar versus the euro.”

Within a stock-picking approach, Carmignac favours defensive stocks, rather than cyclical or industrial stocks, as they have been cheaper relative to market in 20 years only once, he explains. “We are in a more mature stage than the early cyclical rebound that we have seen in the past 18 months, so we think that industrials are a bit expensive, and the poor relative performance of defensive stocks makes them attractive.” The financial sector – especially the banking sector in the eurozone, and partially in the UK, which could be affected by the Irish debt – is still to be largely avoided , says Mr Le Coz.

ACTIVE APPROACH

The remarkable differences between sector performances in Europe make it important to employ an active management approach in European equities, explains Hans Peterson, global head of investment strategy at SEB Wealth Management. “We are confident in active fund managers that are focused on industrials for example rather than banks, which are still a big part of the index,” he says, explaining that a good bet are also consumption companies in the food or beverage sectors for instance.

With the current valuations today, it is not that important to distinguish between growth and value style. “We would look for some sort of Garp-like style – growth at good price – like for example we see in some parts of the industrial segment; it is more of a growth driven style,” explains Mr Peterson.

“There is still quite a big risk premium on Europe as a whole, due to the difficulties in governments’ finances. Also, there is still hesitance towards the sustainability of the business cycle, which has pushed valuations down to quite attractive levels.”

European equities have a neutral weight in SEB’s allocation models, but within it Germany and the Nordic countries are a big overweight. “We have quite a positive view on both Sweden and Nordic equities, as a whole. Sweden has an extremely strong industrial position that benefits from the growth in emerging markets. Having a strong exposure to the world growth is key for investing in Europe today,” he says.

Apart from a few notable exceptions, such as Nokia and Ericsson, the Nordic equity space is substantially represented by mid or small caps. The Scandinavian countries are an interesting bet, explains Mats Andersson, portfolio manager of the Nordea Nordic Equity Small Cap fund. They have ridden out the financial crisis quite well, they have good balance sheets and a healthy banking system compared to the rest of Europe. Sweden in particular is leading the recovery, but Norway has a strong economy and Finland and Denmark are also attractive.

Exposure to the domestic markets accounts for around 50 to 60 per cent of Nordic companies’ revenues. The global market accounts for the remainder, with emerging economies becoming increasingly important. Small caps, leaders in specific niche sectors, such as Seco Tools in Sweden, have a very strong position globally and have benefited from being early movers into the Far East, says Mr Andersson.

Finnish companies, which have a very strong foothold in Russian markets, enable investors to gain exposure to the country’s domestic consumption story, without being exposed to the political risk of investing in Russian companies directly.

“Via Nordic small caps, especially in Sweden, Finland but also Denmark, investors get exposure to emerging markets at a lower risk,” says Mr Andersson. This applies to the industrial sector, but also the pharmaceutical sector, through Danish companies like Nova Science or Nova Nordisk.