European equities could provide haven amid global uncertainty

Rory Bateman

Rory Bateman

Head of Equities

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  • Greek threat subsiding
  • US rate rise likely 'priced-in'
  • China slowdown will weigh on exporters
  • Domestically focused companies favoured

Three key risks for European equity markets

We have highlighted previously the three ‘knowable’ key risks for equities:

  • Greece and eurozone turmoil
  • US interest rates
  • A possible China ‘hard-landing’

We have some respite from the Greek crisis given the recent bailout agreement and whilst there remain many unresolved issues, there is a clear determination from the authorities on both sides to reach agreement.

With regard to the turn in the US rate cycle, never has there been so much coverage and anticipation of the Federal Reserve’s move and we believe therefore the change is probably ‘priced-in’.

In any case, over the last 25 years the US equity market has initially reacted negatively as interest rates increase, but the reaction is temporary and has reversed within six months as the underlying health of the economy and corporate profits become the key drivers.

The slowdown in China has been inevitable, but the degree of slowdown is an area of considerable debate and the trigger for recent market volatility.

European equities offer almost ‘safe haven’ status in a world of increasing economic uncertainty.

We recognise that China has been through a government-led, credit-fuelled expansion focused on investment and infrastructure.

The economy needs to transition more towards consumption and the government needs to ensure this rebalancing occurs without the economy collapsing.

Recent market volatility has been caused by fears that the Chinese authorities will be unable to manage this transition and as a result the familiar 7% GDP growth target will be missed.

There have been a series of policy mistakes, such as trying to artificially inflate the stockmarket, which have undermined international investor confidence in China in conjunction with poor manufacturing data which showed the economy is slowing more rapidly than expected.

China threat to export industries

Sadly our ability to predict Chinese policy is very limited but we do know that around 10% of goods exported from the EU go to China, nearly 70% of which are within the machinery, transport and chemicals sectors.

Whilst the growth of exports to China has been 9.8% p.a. from 2010-2014, the absolute amounts involved are small at €165 billion when compared to intra-EU traded goods which is approximately €2.8 trillion.

Domestically-oriented stocks are seeing stronger positive earnings per share revisions than exporters but on average trade at a substantial discount.

Our belief is that the long awaited recovery in Europe is happening and whilst specific industries will be impacted by a Chinese slowdown, the momentum around Europe should continue given expanding credit, structural reforms, improved business confidence and increasing consumer expenditure.

As a reference point, it has taken seven years for the size of the eurozone economy to exceed the level achieved in 2008.

Exports to China helped prevent an even worse European recession during the eurozone crisis, but now the much more important domestic engine of growth will ensure the European economy can grow despite the Chinese situation.

Domestic bliss

At the portfolio level, we particularly favour companies whose operations are focused on the domestic economy.

Domestically-oriented stocks are seeing stronger positive earnings per share revisions than exporters but on average trade at a substantial discount.

Whilst we believe the European recovery is on track and the impact from China will be limited, we acknowledge that deflationary pressure from commodities and imports is likely to feed into inflation expectations.

In addition, continued currency devaluations in the emerging markets will reduce the relative competitiveness of the euro.

These issues may demand a policy response from the European Central Bank at some point but our belief for the coming 12 months is that European equities could offer a relative ‘safe-haven’ when compared to other markets around the world.