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Europe - May 2015
EuropeanMay 5 2015

Risks in Europe eclipse the rewards

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Investors rotating into Europe on the back of positive data and the launch of quantitative easing (QE) may be caught out if import demand from Asia continues to slow.

Chinese growth has slowed to its lowest level in almost a quarter of a century, which may dampen Europe’s recovery. The Middle Kingdom posted a 7.4 per cent rise in GDP last year, down from 7.7 per cent a year earlier. The Chinese government has also scaled back its growth target for this year, with a goal of ‘just’ 7 per cent.

Asia is highly dependent on China and, as a region, it imports about 17 per cent of Germany’s total exports. That makes it the European powerhouse’s largest market, behind the eurozone. If Asia stops buying as much as it has, it is likely to hit German exporters, which have until now been the train pulling the rest of the currency bloc behind it for the past few years. Even so, the Dax has jumped by more than 20 per cent year to date in local currency terms, driven by the depreciating euro as investors anticipate an earnings pick-up. More broadly, the eurozone has returned 18 per cent, compared with the MSCI AC World index’s 5 per cent gain, as QE is unleashed into the currency bloc.

Positive data has recently come out of Europe, which has led to greater confidence in European stocks, but that alone will not necessarily push markets higher. The International Monetary Fund issued 1.2 per cent and 1.4 per cent growth targets for Europe this year and next, relative to 2.4 per cent in both years for advanced economies in aggregate. There is room for upside, but there remains a disconnect between economic performance and stockmarket returns that should be heeded. Eurozone companies are not cheap versus other developed markets, and earnings forecasts could turn out to be overambitious.

There is more chance of QE failing to stimulate the real economy than in other advanced economies that have embarked on such a strategy. European banks remain broken, which impedes the flow of cash from the European Central Bank (ECB) through the financial system. Also, a lower rate of home ownership on the continent will dampen any wealth effects that flow through to the consumer.

There are other major structural headwinds. While Europe’s deleveraging is slowing and credit acceleration (which tends to lead real growth) has spiked in the past year, it is still the large companies doing the borrowing, and they are likely to invest this money overseas. Any extra cash consumers find in their pockets from sharply lower petrol prices is also unlikely to make it into the real economy, and instead used to pay down debt. In defence of Germany, it is likely its consumers will spend more, given their already considerable savings rate.

In the area of small- and medium-sized businesses in Europe, these firms constitute a larger portion of the economy than in the UK or US, and their financing options remain limited – that is possibly why eurozone hiring data remains so sluggish. A decade of wasteful spending and poor investments is yet to be fully unwound and banks are still repairing their balance sheets. Governments, too, are hamstrung. Agreements to get public spending back to reasonable levels mean annual eurozone GDP growth is expected to cause between 0.25 and 0.75 per cent drag each year between 2015 and 2019. By contrast, the US will be boosting its coffers by 2016, with the US government budget set to become a net contributor to GDP growth.

And let’s not forget Greece. The immediate impact of the Greek economy breaking away – with its relatively small GDP – is negligible, given the overall size of the eurozone. But the potential for a ‘Grexit’ to spark a revolt from other peripheral states, such as Spain and Portugal, cannot be ignored. Nor can we ignore the prospect of Greece, potentially cast adrift from the west, forging new alliances with Russia and ratcheting up geopolitical risk.

Relative to analysts’ forward earnings estimates, European stock prices look stretched. Analysts are forecasting 16 per cent growth in European earnings per share (EPS) this year, compared with 3 per cent in the US. Given that EPS surprises matter as much as EPS growth, it seems more likely that European companies will disappoint this year.

So the risks in Europe seem to outweigh the rewards. Indeed, there’s a significant chance that Europe will remain the weakest source of developed market growth for a number of years.

Julian Chillingworth is chief investment officer at Rathbone Unit Trust Management