Friday, August 26, 2011

Europe Zero Percent Growth - What is the Impact?

With soft economic data and weak investor sentiment, Europe's equity markets have been saddled with additional worries apart from the on-going sovereign debt crisis. We assume a scenario of 0% annual GDP growth, as per our analysis on the US, for 2011 and 2012 to stress test European earnings by proxy of the Stoxx 600.

* Recent economic data point to a significantly more moderate pace of growth for the continent.

* We think growth will ease, but do not expect a full-blown recession.

* To account for recent soft economic data, we stress-test Europe earnings on the basis of zero percent economic growth in 2011 and 2012.

* Our stress-test indicates that even if growth stalls in 2011 and 2012, Stoxx 600 earnings will only be 3.6% below its all time high recorded in 2007.

* Even after revising down earnings estimates on non-existent economic growth, we see fair value (at the end of 2012) for the Stoxx 600 at 321.5 points, a hefty 35% above current levels.

* Europe's equity market valuations remain attractive despite soft economic data and weak investor sentiment.

* We maintain a 4.0 star “attractive” rating on the European equity market.

Consensus estimates for US economic growth for 2011 have been downgraded on the back of high uncertainty about US domestic demand, still-depressed housing prices, weak labour market and the threat of a double-dip recession. With the recent downgrade by S&P on the credit rating of the US, financial markets are rife with volatility (the VIX index, a measure of volatility, rose as much as 105% from 3-5 August) with equity markets across the globe declining in an unprecedented free-fall fashion since the Great Financial Crisis.

Similarly, Europe has seen similar indicators of a slowdown in economic growth amidst the worrisome sovereign debt crisis and high commodity prices. Forward looking indicators such as the Purchasing Managers Indices (PMI) have fallen to its lowest levels in the core European nation of Germany where the PMI for manufacturing is at its lowest level since October 2009 and its PMI for services at its lowest level since February 2010. Other forward looking indicators such as business confidence and economic sentiment have also been falling in Germany and France, where in the former, the IFO business climate index is at a 9 month low and the ZEW economic sentiment survey experienced 5 straight months of decline.

With such doom and gloom plaguing the markets, we assume a similar scenario of 0% annual GDP growth, as per our analysis on the US, for 2011 and 2012 to stress test European earnings by proxy of the Stoxx 600 which fell as much as -8.09% since the US credit rating got downgraded by S&P on 5 August 2011.

With much pessimism over the state of the global economy, we stress test the European economy at large, assuming 0% annual GDP growth for 2011 and 2012, as compared to consensus estimates (table 1). With Real GDP growth of 0.84% on a quarter-on-quarter (QoQ) basis for Q1 2011, in order to derive a 0% annual growth, we had to assume negative quarterly growth rates for Q2-Q4 2011 between -0.80% and -1.10% as seen in table 2. (Q2 2011 GDP was released on 16 August 2011, the Euro Zone grew at 0.2% QoQ, missing consensus estimates of 0.30%)

Table 1: Consensus Estimates
Consensus Estimates

Table 2: Stress Test
Stress Test

Taking a peek into the major components of GDP and ignoring market noise, household and capital formation actually grew in Q1 2011 on a quarter-on-quarter basis, with rates of 0.22% and 1.88% respectively. While household consumption is currently around its 6 year average, capital formation is still below its previous peak as well as -9.1% below its 2005-2007 average. (chart 1)

Aggregated Accounts

With capital formation remaining below pre-crisis levels, we believe this signals potential room for growth in corporate investment on the backdrop of lesser than normal fixed capital investment. Similarly, household spending has room for expansion given the abatement in high commodity prices. Conversely, we do not believe that government expenditure has room to grow given the austerity measures being passed across Europe as countries scramble to reduce their budget deficits and rebalance their sovereign balance sheets in order to either fly under the radar of traders looking to punish them via higher yields, or, to gain funding and support from the European Financial Stability Fund (EFSF) and European Central Bank (ECB).

Regardless of the possible upsides to European GDP, given the market panic of a possible recession in the US and weak economic data emanating from Europe, we assume a worst case scenario of 0% GDP growth for the continent due to the potent combination of persistent sovereign debt issues and reduced external demand stemming predominantly directly or indirectly from the US, whose effects would be felt globally.

With the assumption of GDP growth stalling, we adjust earnings estimates to account for the slowdown in economic growth by assuming that revenues, not only stand still at their current levels, but actually decline for the Stoxx 600, while we reduce the profit margin for additional conservatism. For simplicity, we assume revenues decline/grow at a similar rate to GDP (QoQ) as per our stress test in Table 2 with the results seen in Chart 2.

Stoxx 600 Revenues

As for the Stoxx 600’s profit margins (chart 3), we discount them due to a potential increase in the lending rates by banks in Europe, a by-product of the current on-going sovereign debt crisis, affecting corporations through higher interest expense as well as potential increases in provisions for various write-offs. The actual impact of a significant slowdown in the US will also affect the net margin of corporations with significant earnings derived directly or indirectly from the US. All in all, we discount profit margins for Europe by -13.00% for 2011 based on the above mentioned factors.

In 2012, we discount the profit margin by -5.00% , based on expectations of an implied increase in funding costs (which are already artificially low) as well as mild inflation through rising costs of inputs such as labour as well as commodity prices (which have declined significantly) yet again. It is also based on the expectation that profit margins normalize and eventually revert back to levels slightly below its high just prior to the financial crisis.

Stoxx 600 Profit Margin

Despite our stress-test scenario depicting gloom in Europe, the projected Stoxx 600’s earnings hold up in the face of scrutiny (chart 4). With earnings per share (EPS) of 21.14 and 25.72 for 2011 and 2012 respectively, our EPS for 2012 remains a mere -3.59% below its all time high of 26.68 back in 2007 prior to the crisis. While lower than consensus estimates, it should be remembered that our stress test literally puts Europe in a recession and as such, a difference of -7.45% between the optimistic consensus estimates and our pessimistic scenario is acceptable.

Stress Test Earnings

While economic indicators spell headwinds for Europe, our stress test attempts to put the continent through a rain of pain. Recent earnings results from the 331 companies to have reported earnings during April – July had an average earnings growth of 8.90% compared to a year ago. With 190 out of the 331 companies posting positive surprises, it is clear that the majority of companies are in good shape. The positive surprises were hampered by the financials which had earnings growth of -11.89% with 37.5% of companies within the troubled sector posting negative earnings surprises, a result of the on-going sovereign debt crisis.

On these conservative assumptions and at 12.5x 2012 earnings, the fair value for the Stoxx 600 is at 321.50 points based on stress test data, representing a potential upside of 35.17% over the closing price of 237.85 on 15 August 2011. From our base case scenario, we are projecting an upside of 66.5% with the Stoxx 600 hitting about 396 points. Investors who have a long time horizon for investments may consider Europe, through a Regular Savings Plan which utilises the concept of dollar cost averaging, which is a great tool for reducing the chances of buying at a peak in price during volatile times like these.

Source: FundSuperMart
Author : iFAST Research Team

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