European Equity Team Market Barometer
Following the risk-on rally seen in Q1, Q2 brought higher volatility and increased risks, as enthusiasm from the second Long-Term Refinancing Operation (LTRO) injection by the European Central Bank (ECB) faded. Markets pulled back, driven by weaker macroeconomic data and by the escalation of the political crisis in Europe. On the macroeconomic front, the deteriorating momentum in leading indicators across the US and Europe, coupled with the ongoing weakness in China, have increased the downside risk to global economic growth prospects. On the political front, initial Greek elections in April and the failure to form a pro-eurozone coalition triggered a renewed widening of sovereign spreads and the resurgence of eurozone break up fears. The widening has been noticeable in Spain in particular, with increased risks of Spain requiring a bail out to recapitalise its banking system. As we approached the end of the quarter, markets rallied sharply as the latest European political leaders' summit managed to surprise on the upside, with more support given to the periphery and the banking system in particular.
1. Macro Outlook
Macroeconomic momentum is weakening in both the US and EU, whilst data continues to come in weaker than expected in China. Momentum in leading indicators has been deteriorating since March, which is likely to lead to further economic weakness in the coming months. Chinese policy makers are renewing initiatives to stimulate economic momentum on a carefully orchestrated basis. As a result we expect a pickup in Chinese economic momentum in the second half of 2012. US economic momentum has also been weakening, and there is a risk of this continuing into the second half. European economic momentum has continued to weaken, deteriorating markedly in periphery countries, as austerity measures put pressure on businesses and consumers. Worryingly, the weakening momentum in Europe seems to be spreading to the core. In this context, we see macro risks remaining high on the economic front. The political crisis in Europe has clearly taken centre stage once again. Given the significance of political outcomes on the future of the eurozone we have added a synopsis of our views below:
2. Political Outlook
The eurozone is still going through a crisis, with a clear need to move towards deeper fiscal and political integration. The market is clear about what needs to happen: a clear commitment to sovereign debt reduction, and the recapitalisation of the European banking system. Both mooted solutions could progress faster if Europe moves towards a deeper fiscal and political integration and a banking union. However, political opposition remains high, with Germany unwilling to accept a common responsibility for eurozone debt, preferring instead to impose austerity measures and structural reforms to bring budget deficits down across the 17-nation bloc.
Against this backdrop, there is a growing discontent by countries impacted by the severity of austerity measures and with it resistance to continue on this painful path, combined with a reluctance to relinquish sovereignty over fiscal affairs.
The crisis has the potential to widen further, through any of the following scenarios:
-A eurozone break-up, voluntary or involuntary, through the periphery or the core
-A widening of the sovereign debt spreads increasing refinancing pressure on countries
-Spain needing a bail out, with the risk of contagion to Italy and ultimately to France
-A banking collapse, with increased bank runs and/or failure as liquidity dries up
There are actions that policy makers could take to avoid, contain and indeed solve the crisis. The ECB could inject liquidity through further LTROs, further easing in collateral requirements, renewing the Securities Markets Programme, further interest rate cuts to reduce funding costs, and implementation of outright quantitative easing.
We see the last option as unlikely, whilst the former would be relatively easy and rapid to implement. The European Stability Mechanism (ESM) could also be issued with a banking licence, and ESM or European Financial Stability Facility (EFSF) funds could be used to recapitalise the banking system. A banking union could be formed, an EU-wide deposit insurance scheme could be introduced to minimise the risk of bank runs, and there could be measures to force EU banks to recapitalise. Finally, a Eurobond or a European Redemption Fund could be created, which would be the most radical solution, effectively leading to sharing the debt burden among all EU member states. We acknowledge that there is major divergence in views on this last option amongst EU countries, with Germany being clearly against such a measure.
The continued political indecision in the eurozone and the widening of sovereign spreads is leading to a high state of uncertainty, which is impacting both consumer and business confidence, leading to deteriorating economic outlook.
3. Corporate Earnings
Our forecast for corporate earnings growth for 2012 has been less optimistic than consensus and remains around zero. Consensus market estimates for 2012 have now come down a long way, from about 12% growth expected in the summer of 2011, to about 3% today. As flagged above, weakening momentum in global leading indicators and political uncertainty impacting business and consumer confidence are contributing to the renewed negative earnings momentum, which is particularly apparent from the recent number of profit warnings. The deleveraging trends in the European banking system continue, which is leading to reduced availability of credit, which in turn contributes to the general weakening in economic activity.
In our view, downside risk to earnings still exists, and we are monitoring global leading indicators closely to that effect. However, we do see offsetting effects to the downside earnings trends; the sharp weakness in the euro is improving growth prospects of exporting companies, whilst weakening commodity prices will ease pressures on inflation and input costs, thus helping corporate margin trends.
In this uncertain macro and political outlook, companies' earnings will be impacted to varying degrees, which highlights the need to focus on stock picking backed by detailed proprietary company and industry analysis to identify attractive long-term investments for our clients.
4. Investor Positioning
We have seen outflows from global equities and in particular, European equities, into other asset classes, notably corporate bond funds, driven by extreme risk aversion. In terms of allocations to Europe, we are now at a decade-low point, driven by the items highlighted above. In our view, this in effect highlights the potential for a sizeable return of flows into European equities with the removal of the political uncertainties and greater visibility on the future of the eurozone. Despite earnings slowing, European equities remain extremely attractive on a historical valuation basis (using price/earnings ratios, price-to-book ratios, or dividend yields for example), but clearly a return of confidence is required for this value to be unlocked. Interestingly, these sorts of metrics have been attracting the attention of deep value, contrarian and income investors.
Overall Outlook
The outlook remains uncertain, and investors have to be mindful that the crisis could escalate further before improving. However, we have been able to demonstrate that active portfolio management can generate alpha in such conditions. From an investment standpoint, Europe offers an abundance of attractive international franchises, with exposure to long-term structural global growth trends which are extremely attractive. We see incredible value in stocks that have reached oversold levels based on our internal fair value estimates. At the same time, Europe offers the highest dividend yield of all developed markets, given its long list of cash-generative companies with the potential for enhanced yield and cash return to shareholders. This is an attractive proposition for investors looking for enhanced dividend income in a world where yields are at extremely low in other asset classes. Europe has become a fertile hunting ground for investors seeking attractive value names, quality companies, and income potential.
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