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Europe: The Good, the Bad and the Overlooked

Morningstar's regional editors give the local view on investment prospects in Europe

Holly Cook 14 November, 2012 | 8:00AM

When it comes to investing internationally, local expertise and understanding are key to making informed decisions. Media headlines might tell the news, but only the juiciest--or most depressing--will sell newspapers. For a more measured and locally informed view, I recently spoke to several Morningstar editors based on the ground in our offices around Europe to gain an insight not only into the economic outlook but also into how regional investors are feeling about the future.

The Good?
Depending on which European economy you choose to look at, the resultant picture of the region's economic health will be markedly different. Germany, for example, has long been the region's leading economic force, but even this powerhouse is suffering in today's climate. 

"Although Germany is seen as a safe haven by equity and bond investors alike, growth will slow down going forward," says Ali Masarwah, editor-in-chief of Morningstar's Germanic websites. "While the German government--naturally--tends to take a much more optimistic view compared with most economists, even official Berlin forecasts do not expect gross domestic product growth to exceed 0.8% in 2012." 

Until recently, the German government had been pinning its hopes on economic expansion to the tune of 1.6% in 2013, but last month this estimate was brought down sharply to just 1.0%. Masarwah says, "Arguably, Germany will not be spared from the recession in the eurozone, though local growth rates are still pretty robust compared with the expected EU-wide rates."  

The European Commission sees the eurozone contracting 0.4% this year before returning to tentative growth of 0.1% in 2013. 

So how do German companies fare against this backdrop? It appears that cost-cutting has had the desired effect, but the economic slowdown is taking its toll on companies' earnings power. "The latest reports show DAX companies increasing top-line growth but facing depressed earnings at the same time," says Masarwah.  

 Volkswagen (VOW), for example, saw revenues rise 27% in the third quarter while earnings fell by 19%. 

In general, Germany's corporations are in pretty good shape, but how much of an impact the economic environment will have remains up for debate. "With Germany being very much geared to exports, a lot will depend on the global economic predicament of 2013," Masarwah notes. "However, internal consumption is picking up, with the jobless rate down to a 20-year low of 6.8%, which will mitigate the slowdown." 

That said, earnings revisions might well hit stock prices in the short term. 

It's interesting to note that despite expected economic weakness, German investors are becoming more sanguine on company valuations. Masarwah quotes data from the Institute DAI (Deutsches Aktien-Institut), which indicate that the number of private individuals investing in mutual funds and equities has risen at an annual rate of close to 25% in the first half of 2012. "This stands in stark contrast to past years," Masarwah says. "Until 2012, German investors were behaving as if the world's end was imminent. They have been piling into cash, bonds, and savings accounts and have long abstained from equity investments."  

Is this a sign that the tide is turning permanently in Germany, or is 2012 something of an anomaly? It's hard to say for sure, but Masarwah notes that investors tend to mistime the markets and so abstaining from equity investments rather than piling money in could turn out to be a good idea, he muses. 

The Bad?
"The consensus for the Spanish economy is that we will suffer a severe recession this year and that this recession will continue during 2013," says Fernando Luque, editor-in-chief of Morningstar's Spanish website. "The most optimistic view (from the government) is that we will see the light at the end of the tunnel during 2014." 

Greece might still dominate many column inches in the press, but Spain and Italy have long been the focal points of the eurozone debt crisis for economists and investors alike. The "will they, won't they?" seesawing over whether the Spanish government will eventually request a bailout is enough to make any investor tire of the debacle, but Luque is assured on his views. "The key point is when, not if, the government will ask for the bailout," he says. "My sentiment is that the government will wait as long as it can because asking for this rescue remedy is akin to recognizing political defeat, and no politician wants to admit that." 

The markets, however, will force the Spanish government's hand, Luque believes. If the politicians wait too long before making a decision, credit market mechanics will see to it that the risk premium rises so rapidly that an official rescue request is unavoidable. 

As always, how this situation feeds into domestic corporate health is dependent on individual companies' makeup. "In general terms, Spain's large companies have healthier balance sheets than the government--no surprise there," notes Luque.  

These companies have already done their homework and made crucial cuts to costs--a fact registered in the corresponding increase in the country's unemployment rate. But Luque says, "The big problem is that credit is not flowing to end-consumers, and so my guess is that sooner or later these companies will also feel the pinch."  

Spain's best-known companies on the global stage--companies of the likes of
 Telefonica (TEF) and  Santander (SAN)--have the benefit of having diversified into emerging markets. This lifeline "is a very positive element" for future corporate prospects, says Luque.

In Italy, where the Italian Statistic Office, Istat, is forecasting GDP to shrink by 2.3% this year with the risk of downward revision should "global trade slow down and tensions on financial markets sharpen," even the government is struggling to put on a brave face. In contrast to several other eurozone countries, the Italian Treasury's own estimates do not attempt to put a rosy sheen on the outlook and instead put economic contraction at 2.4% in 2012, notes Sara Silano, editor-in-chief of Morningstar's Italian website.

Italian companies have become more prudent in hiring and investing since the financial crisis took hold, Silano says. Italian banks, for example, are trying to trim costs and build capital as the country's third recession in a decade and higher funding costs related to the sovereign debt crisis curb profits. But earnings remain weak among Italian companies, with the profitability of the country's five largest lenders dropping by about one third in the first half, according to a Bank of Italy report published in October. 

As in Germany and Spain, the more stable companies will tend to be those that have diversified revenue streams, but the flip side is that a squeeze on demand coming from abroad--whether from other eurozone countries or emerging markets--will be another thorn in their side. 

The Overlooked?
From a global perspective, the Nordic economies are often overlooked when it comes to talk of Europe and European investment prospects. Iceland may have earned its fair share of headlines toward the start of the financial meltdown, but the Nordic nations have often been omitted from international commentary on investment prospects. 

Simply put, the three Scandinavian countries of Denmark, known for its shipping industry and wind energy; Norway, of oil and seafood fame; and Sweden, engineer and telecoms provider; plus eurozone-member Finland, known for its forestry products and mobile phone giant  Nokia (NOK1V), together offer a wide array of secondary and tertiary industries. Yet looking in on the region, it would appear that the Nordics have remained relatively resistant to the weakening demand seen elsewhere. 

Closer to home, however, it seems change may be afoot. "There has been a pile of negative news in recent weeks in the Nordic countries," says Matias Möttölä, editor-in-chief of Morningstar's Finnish website. "Several large companies have announced major layoffs, and forward indicators show businesses and consumers have become much more pessimistic about the prospects of the economy." Much of this has to do with the global slowdown. "As small, open economies, the Nordic countries are particularly dependent on export demand," Möttölä points out, not just from Europe but more and more so from Asia. "Bad news from those regions is bad news for Nordic companies and negative for investor sentiment," Möttölä says. 

Despite this pessimism, however, companies are still displaying individual strength. "The financial crisis was a big warning to companies to clean their balance sheets, and companies are still financially fairly well-off as they have been very prudent about investing and hiring in the last few years," says Möttölä. 

Invest in Companies, Not in Europe
Irrelevant of endless headlines of doom and gloom in the European Union, a 27-strong group that excludes Norway, Switzerland, and numerous peripheral and emerging European economies, the European region as a whole offers a huge array of social, cultural, economic, and political systems. 

As evidenced by conversations with Morningstar's European editors, there are undoubtedly similarities among the challenges faced by corporations--and politicians--in Europe, but these are generally not much different from those faced by companies in the United States or indeed in Asia. Crippling sovereign debt is the scourge of the developed economies, but weak global growth affects all. 

Against this backdrop, and while all economies feel the pinch, there continue to exist numerous companies that offer long-term competitive advantages. Clearly certain sectors will play host to more problems than others--I suspect few investors would be willing to plow money into a regional Spanish bank right now--but investors should do well to focus on companies that are well-established in their markets; generate revenue from a diversity of regions, including the emerging markets; and look attractively valued on a long-term basis, in part because of negative sentiment at a regional level. 

Morningstar Europe editors Ali Masarwah, Fernando Luque, Sara Silano, and Matias Möttölä contributed to this report. 

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

Securities Mentioned in Article
Security NamePriceChange (%)Morningstar
Rating
Banco Santander SA7.60 EUR0.13
Nokia Oyj6.31 EUR-1.41
Telefónica SA12.06 EUR-0.08
About Author Holly Cook

Holly Cook  is Managing Editor of Morningstar.co.uk