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.”
