European equities: A half-time reality check

In simple terms, it is our contention that the setting up of a €750bn rescue package by the ECB and IMF is designed to prevent another Lehman’s type event. The ECB’s effectiveness in preventing another major credit crunch or significant deleveraging of the banking system is difficult to predict, but the magnitude and decisiveness in establishing the fund is a good starting point.

While there are people far more qualified to argue the likely policy responses and economic outcomes we could see over the coming months, let’s make our own position clear. From an economic perspective, we do not view the situation as being particularly bad. In addition, we believe it is highly improbable that the euro will face a political crisis which is exactly what is required to envisage a euro break-up. There will be economic adjustments made through fiscal austerity packages and private sector deleveraging, but we expect monetary policy to remain extremely accommodative. The severity of any slowdown from here will depend on the ability of policy makers to effectively manage the deleveraging requirement using monetary stimuli to prevent a double dip scenario. We feel it’s likely the world has learned something over the last three years or perhaps over the last 20 years from the Japanese experience.

So why are we relatively sanguine about the state of the underlying economy? We spend the overwhelming majority of our time looking and talking to companies that are experiencing the real economy on a day by day basis. Outside of Europe, the economic recovery is actually pretty much on track, China continues to expand, the rest of emerging Asia and Latin America have developing economies without debt issues and not least the USA is on track to deliver 3% growth this year.

Recently the IMF upgraded their global GDP forecast from 4.2% to 4.6%. There is undoubtedly a crisis of confidence in Europe from within and externally which has had the effect of depreciating the euro exchange rate which in itself will significantly benefit eurozone exporters. Year to date, the euro currency has already depreciated by approximately 14% vs the US dollar, and 11% on a trade-weighted basis. There are increasing opportunities to buy competitive multi-national companies with exposure to global markets on much lower valuations than in other regions. The euro countries cannot rely on exports alone, but we believe with sensible policy decisions, Europe can emerge from this period stronger and more resilient.

From a valuation perspective, in absolute terms (versus other major equity markets and other asset classes), European equities have rarely looked so attractive. Government bond yields are near historic lows with equities yielding more than safe-haven fixed income securities such as German bunds and US treasuries. At 12x prospective earnings, Europe is trading well below the historic 15x average and well below the US S&P composite also on 15x prospective earnings. European companies are expected to deliver 16% earnings growth in 2010 and possibly more in 2011 as European banks earnings recover.

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