- Recent economic data point to a mild recession for the continent, not a complete collapse circa 2008-2009
- Consensus estimates of GDP growth have been overly-optimistic during times of economic slowdowns
- Soft economic data, poor sentiment and a debt crisis that rages on spells trouble for Europe
- Financial sector has been clobbered, worries over funding persist as staff lay-offs have begun
- Our conservative estimates forecast potential upside of 24% by 2013
- We downgrade the European equity market to an attractive "3.0" star rating
Stocks Declining on Recessionary Fears
The sovereign debt crisis aside, soft economic data, a lack of political cohesiveness and deteriorating confidence have sapped the Eurozone’s growth momentum. The uncertainty and pessimism plaguing the continent has not only endangered its recovery from the financial crisis of 2008, but is threatening to plunge the continent into a new recession. With such an overhang, we revise our outlook for Europe, highlighting risks to the downside along the way.
Our previous article on Europe had tested the Stoxx 600’s earnings based on the assumption of 0% annual Real GDP growth for 2011-2012. However, since the test was done, a slew of new data releases seemingly indicate a further deterioration in the economic fundamentals of the Eurozone has prompted us to reassess the potential downside risks to the continent. As such, we revisit the troubled continent that is Europe.
A quick glance at recent history tells us that consensus has generally been overly-optimistic during times of distress and cautious during times of growth (table 1). With weaker than expected 2Q 2011 growth for Europe (chart 1) spelling stronger headwinds for the continent, we reassess Europe’s economic prospects on a stricter level based on the above.
|Table 1: Consensus Estimates
Source: Bloomberg, iFAST Compilations
Data as of 12 September 2011
Chart 1: Quarter-on-quarter gdp growth disappoints in q2
Given that the ECB has yet to revise its 2012-2013 GDP forecasts (as of 8 Sep 2011) and the poor sentiment towards and on the continent, we reduce our optimism and forecast a recession of -1% for the next 12 months followed by a period of 0% growth for the year thereafter, taking into consideration the current weak outlook and data falling short of consensus expectations (table 2).
|Table 2: Erring on Caution's Side
Source: Bloomberg, iFAST Compilations
Data as of 12 September 2011
A Reduction in Capital Formation, Government Expenditure & Exports
Amongst the different components of GDP, we expect a drop in capital formation, government expenditures and exports. Previously, we had highlighted a potential increase in capital formation (corporate investment), however, given the release of this month’s leading indicators for business confidence, we believe that the plausibility of this has significantly diminished. Furthermore, with capacity utilisation failing to increase, businesses would logically want to utilise existing spare capacity prior to increasing or replacing current capacity.
Government expenditure is still expected to contract further from current levels given the more aggressive and newly approved budget cuts and austerity measures by nations such as Italy, Spain and France. In Italy, the senate has finally approved an austerity package (which includes following Germany’s “Golden Rule” of government spending within its means) which would reduce the nation’s deficit by EUR 54 billion over the next 3 years through reduced government spending and higher taxes. Similarly, Spain has adopted Germany’s “Golden Rule” of keeping budget deficits within a specified limit in its austerity plans. However, government prudence in public spending will negatively affect GDP in the coming quarters. Tax hikes in the various European countries will also see a moderate reduction in the spending by both businesses and consumers alike as disposable income will inevitably be affected.
The outlook for exports doesn’t bring better news. With the global recovery seemingly stalling, we expect exports; one of the key drivers of the recovery thus far, to subsequently decline on the back of weakening global demand and growing global uncertainty as business spending slows.
Across the Eurozone, many of the leading indicators as well as sentiment surveys and the important purchasing managers index (PMI) have started to show a significant decline. The ZEW Expectations of Economic Growth (Chart 2), a self-explanatory survey, has seen a sharp decline over the past 3 months to reach levels not seen since December 2008 as the European authorities failed to effectively contain the reignited sovereign debt crisis.
Chart 2: economic growth expectations have receded
Likewise, consumer confidence and industrial confidence levels (chart 3) have taken a dip along with the ZEW expectations of economic growth as fears continue to grow over the debt crisis, dampening sentiment. While consumer sentiment had been improving over the past year, the recent uncertainty has sent sentiment backtracking on its earlier gains into further negative territory. The treading into negative sentiment territory by industrial companies is more worrying as they have been the main driver of the recovery in Europe. A by-product of the dip in confidence has been the Manufacturing Purchasing Managers index (chart 4) fall to reach 49 (as of 31 August 2011), signalling a contraction in manufacturing (a number above 50 indicates expansion). With negative sentiment on the continent, we expect cautiousness to curtail consumer spending and industrial production as both business and people alike reduce their spending in light of much uncertainty.
Chart 3: confidence levels are low
Chart 4: purchasing managers slowing buys
The current spate of soft economic data has fed the on-going market weakness, which has in turn worsened sentiment and dented confidence. With worsening sentiment, spending might be reduced as many would hesitate spending at a time when the outlook is uncertain, thereby turning the current worries into reality and thus becoming a self-fulfilling prophecy.
While some might argue that the on-going problem in Europe is an issue of sovereign balance sheets and that corporate balance sheets are fine, we believe that the sovereign debt crisis will ultimately infect the financial sector (if it hasn’t already) with the knock-on effects being felt by the economy at large. (As it is, several large European banks have already announced job cuts as they seek to tighten their belts amidst difficult times, vindicating our view that the negative spill over effects will become realised.)
With dark clouds continuing to loom on the horizon and recent weak data, we (once again) revisit Europe’s earnings, this time on the basis of a -1% contraction in GDP over the next 12 months. Europe’s earnings as represented by the Stoxx 600’s earnings are expected to experience negative growth of -23% for 2011, thereafter recovering to post growth of 20.5% and 10.8% for 2012 and 2013 respectively. This is in comparison to consensus growth estimates of 8.1%, 12.6% and 4.7% for the same time frame. Thus, while we are expecting earnings to contract for 2011, we do not expect it to collapse as it did in 2008-2009, under the weight of the current crisis.
Chart 5: Stoxx 600 earnings
Based on our more conservative earnings estimates, Europe’s PE for 2012 and 2013 would be 10.6x and 9.5x respectively, translating into potential upside of 24% by 2013 (as of 13 September) when compared to its fair value PE of 12.5x.
individually attractive, relatively unattractive
On a relative basis, we downgrade Europe to 3.0 stars as the sovereign debt crisis continues to drag on and hamper the economic recovery in Europe with no clear end in sight. However, on a standalone basis, Europe remains attractive with 24% worth of potential upside.
The lack of a firm and viable plan, growing political instability and rising risks to the downside prompt us to seek better opportunities elsewhere. The recent resignation of Jurgen Stark (executive board member of the ECB) has led to speculation that within the ECB resides a divided board, with Northern European members reluctant to continue buying the bonds of its weaker Southern neighbours. Worse still, growing public disenchantment towards bail outs was exemplified in Germany where Chancellor Merkel and her allies were defeated in recent state elections, a sign of rising political risks in individual countries against future bail outs, making it more difficult for European leaders to balance their political capital and the actions required to resolve the debt crisis.
Until Europe is able to finally allay the concerns of investors about potential sovereign defaults and contagion to its financial sector, investors might like to lessen their targeted portfolio allocation towards the troubled continent. Investors who have a long time horizon for investments may consider Europe, through a Regular Savings Plan which utilises the concept of dollar cost averaging, which is a great tool for reducing the chances of buying at a peak in price during volatile times like these.
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HENDERSON HZN PAN EURO EQ A2 EUR
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