Europe (ex UK): Cushioning the fall for equities

European stock markets have fallen by almost half from their peaks of last year. After declining by 15% in October alone, by the end of October the FTSE All World Europe ex UK Index was down by over 38% (in euro terms) year to date.

Slow onset of pain in europe

Europe's relatively low overall levels of household and quoted company debt meant that, when the credit crunch struck, the region was initially less exposed than others. The economic pain came indirectly. The initial fall in western consumption that hit Asian exports was primarily caused by a fall in US consumption. It led to a marked knock-on slowdown in the industrial investment in Asia that has been supporting the region's export-led growth, which then hit the large export-led European economies of Germany and Italy. The slowdown in exports from Germany and Italy affected their economies and, through them, the rest of Europe. European consumption is now falling sharply and the Eurozone is technically in recession.

Strong policy responses after a muted start

European policy responses to the deteriorating situation were, overall, quite slow and timid to begin with compared to those of the US and the UK. But now that the immediate threat of inflation has receded in the wake of softening commodity prices, Eurozone interest rates are set to tumble. Besides further government bail-outs of financial institutions, there are likely to be government bail-outs of large businesses considered strategically important. There will also be country-specific fiscal stimulus packages, although these are going to vary hugely in size.

Looking ahead

The environment for European equities is set to be very difficult for the next 12 months. Germany and Italy are too dependent on export growth, while Spain and Italy will remain mired in their property-induced troubles. The economies of France and the Benelux countries are more balanced but their biggest trading partners are the large European countries so they are indirectly exposed via the larger countries' export woes to the global slowdown. With Europe's economy to remain weak well into 2009, the euro is also likely to be weak. Once the economic slowdown stabilises, however, the euro is likely to strengthen. The outlook for 2009 for Central and Eastern Europe is even grimmer. With Hungary already having had to go to the EU and the IMF for bail-outs, the Baltic states are teetering on the brink of big devaluations which, given their very high levels of household and corporate foreign-denominated borrowings, would be very damaging for their economies. Russia, having lost the confidence of international investors in 2008, now faces the prospect of a loss of confidence in the rouble on the part of domestic investors and the possible flight of oligarch capital.

The corporate earnings picture

The most recent Thomson Institutional Broker's Estimate System (IBES)consensus forecast for European markets ex UK and ex financials showed them trading on 9.5 times 2009 earnings, but this was still assuming 6.5% earnings growth in 2009. If we assume, more realistically, that corporate earnings are going to decline in this downturn by 40%, that is, by twice as much peak-to-trough as in previous downturns, and if we cancel the 6.5% earnings growth forecast for 2009, then European stocks ex financials are trading on an underlying earnings multiple for 2009 of 13 to 14x, which is in line with the long-term historical average. This suggests that the market has been much quicker than analysts to discount what is happening. Given, the near certainty that Eurozone interest rates will to continue to fall and probably result in investors earning, by the end of 2009, virtually nothing on cash, earnings multiples are likely to go considerably higher than where they are now. In downturns, the earnings multiples of cyclical stocks, after initially falling steeply, have a tendency, once the downgrades cycle is past and the earnings outlook stabilises, to then expand.

So the time to buy, in recoveries, can be when multiples look high, and by the middle of 2009 multiples on some European cyclicals could look very high, for the prospective multiples on which such stocks could then be trading would be looking through 2009 to those stocks' market positions and earnings capacity in 2010 and 2011. It will be important to remain underweight in 2009 in most financial and credit dependent sectors such as banks, real estate and consumer discretionary areas, and equity positions should be biased towards defensive sectors and relatively economy insensitive growth sectors.

The income dimension

Yield accounts for a far higher proportion of investment returns during periods of market turbulence, and defensive equity income investing will prove especially important in the low growth environment anticipated over the next few years. European companies are coming from lower payout rates than in the UK and have higher levels of cover and European payouts are likely to converge with the UK. Growth in the European equity income market is also likely to be underpinned by European investors' traditional predilection for bonds; with German bonds yielding only 3.7%, the pressure will be on for them to improve their income stream by buying higher yielding equities, while getting the long term equity upside for 'free'.