Europe is very much a two-speed economy. On the one hand, there are the core European countries such as The Netherlands, Germany and France which are relatively attractive because the consumer is less indebted than his counterpart in the US.
On the other, there are those countries such as Portugal, Italy, Greece and Spain, latterly clumped together under the somewhat pejorative phrase Pigs, which are suffering much more from the credit crunch and from having to stick with the euro.
The UK might also fall into that group, save its ability to devalue its currency, and on a trade weighted basis over 12 months the pound has fallen 33 per cent.
Staying underweight
“Germany, Holland and France are in better shape because their consumers are in less trouble, there is less wage inflation and the Government sector is not as indebted as the Pig economies,” says Paul Whyman, senior investment manager at Fortis Private Banking.
“The problem is that if the UK needs readjustment at a macro level, the currency can take the strain but the Pig economies have to take the pain in the internal sector such as with wage constraints.”
Most analysts and economists are advocating being underweight in Europe because they believe the US will lead the way out of recession. Looking at average valuations on a 20-year basis, then the US is currently on a PE of around 13.8, down from 17 at the market’s peak, far more oversold than European markets which are now on average PE of 8, compared with 14 at their peak.
Mr Whyman, who looks across all markets, says he is underweight Europe because although the region was late into the slowdown, it is not highly resilient and the ECB has also been behind the curve in reducing interest rates.
Government initiatives
“Arguably the slowdown in Europe will not go so deep and the high level of social security will help stabilise the economy,” he says. “But Eastern banks are heavily dependent on overseas capital and so a lot of Continental European banks put money in these areas and now those banks have a problem,” explains Mr Whyman.
Government initiatives across Europe may have unleashed a vicious cycle where the remedies to the financial turmoil - the bank bailouts and stimulus plans – have created a backlash that could worsen the crisis. Economic hardship and rising unemployment have already sparked protests in Greece, Bulgaria, Latvia, Lithuania, Madagascar, France and Russia, and protracted demonstrations helped to bring down the government in Iceland.
Protectionism could worsen and stoke instability. The mood amongst British workers, for instance, is becoming uglier in relation to the use of foreign contract workers.
The big macro debate is whether the deflationary argument will win and markets suffer further or whether the fiscal policies will be sufficient to revive the economy.
Debbie Boys, head of the Europe equity funds sector at Standard & Poor’s Fund Services, says that many fund managers are very bearish, believing that earnings forecasts will continue to shrink and that the bad news is not fully discounted. “It’s a more tactical market, and fund managers talk of having to be far more alert to newsflow,” she says.
Nowhere to hide
“I’ve never seen such personal fear in the markets,” Ms Boys adds. “It’s difficult to find a place to hide. It’s hard for fund managers to swallow their losses, stand up and look as though they are in command when what they are feeling is: ‘What the hell do I do now?’”
Tom Stubbe Oulsen, manager of the Nordea-1 European Value Fund, is not too concerned about weightings in individual countries but he believes that the UK is the hardest hit by the credit crisis and difficulties in the property and financial sectors.
“We’re wary of the addition of public debt and the danger of inflation and these concerns are already at least to some extent reflected in the currency,” he explains.
“We may see continued weakness of the pound, but a lot of the damage has already been done,” he says.
“The fact that other European countries do not suffer from the UK malaise does not itself make them interesting,” Mr Stubbe Oulsen adds.
“Germany has no problem with the property market, for example, but it has still been hard hit because it is such a big exporter. These things ripple out like rings in water.”
A common complaint is that the market has not been differentiating between good and bad stocks. “The macro-economic data is still poor, but sometime in the second half of the year there should be a return to valuation basics and good stock-picking will again produce alpha,” says Miguel Corte-Real, investment director at Fidelity.
