Europe awaits impact of credit crunch

Many analysts are sanguine about the impact of the American credit crisis in Europe, but the full extent of its effect is still unfolding, with Germany’s banking sector already reaching crisis point.

Eurozone growth suffered a setback in the third quarter, as a consequence of the unwinding of the American credit crisis. In response, the European Central Bank has cut its 2007 GDP eurozone growth forecast to 2.5% from 2.6%, although it retained its 2008 estimate at 2.3%.

Not surprisingly, the third quarter did not exactly have the most auspicious start – figures from the Organisation for Economic Co-operation and Development revealed European growth was just 0.3% in the second quarter, compared with 0.7% in the first quarter.

The true extent of the American credit crunch has yet to be felt in Europe, however. Many analysts are predicting that it will take at least a year for many companies and funds to assess the damage caused by their exposure to the American subprime mortgage market.

American strategists at Merrill Lynch estimated that losses from the subprime market had hit $170 billion (£84 billion) as at the end of August, based on a $1.2 trillion subprime market. Furthermore, it acknowledges that this could be revised upwards given the extent of the crisis.

The banking sector in Germany – the eurozone’s biggest economy – has already hit crisis point, which has subsequently affected consumer confidence. A recent consumer confidence survey by GfK, a market research group, revealed that projected confidence in Germany fell from 8.5 in August to 7.6 for this month – the lowest figure for six months.

German banks have clubbed together to cover €3.5 billion (£2.4 billion) of losses notched up by IKB Deutsche Industriebank as a direct result of its exposure to the American subprime market. However, this amount is alleged to cover just one-fifth of the bank’s total exposure. This is in addition to €2.5 billion stumped up by IKB’s majority shareholder, state-owned KfW.

Nigel Bolton, head of European equities at Scottish Widows Partnership, says: “Germany has been worse impacted by the US sub-prime crisis. It has caused a lot of angst in its financial field.” He adds that there is a danger that the bearish performance in its banking sector will impact on Germany’s growth, though he says exporting companies are unlikely to be affected because of their relatively low capital requirements.

Nevertheless, performance in Germany will remain volatile for the moment, with its investment banks expected to reveal poor third-quarter performances. Robert Quinn, European equity strategist at Standard & Poor’s, predicts 2.3% growth in Germany, which he says is more sustainable than the 2.8% high of 2007.

Banking in Italy has been unscathed by the American crisis. Charles Dautresme, a strategist at Axa Investment Managers, attributes this to the country’s traditional structure, which is not reliant on securitisation as a source of funding. He says: “We have been underweight in banks and have been since early July, which I think was a good call. Valuations have dropped quite significantly during the correction. In Europe, earnings growth is still at 8% – but our view is that that is a bit too optimistic.”

Dautresme expects this earnings-growth figure to be “trimmed” to below 5% once analysts revise their models on return to work after the holiday season. “That will put some further pressure on bank valuations in Europe,” he adds.

Dautresme says that, financials aside, it is difficult to tell which sectors are likely to be hit hardest from the American crisis. However, Scottish Widows’ Bolton says there is too much focus on America, with China, India, Brazil and Russia being effectively more influential on European growth. Instead, he says, focus should be on the consequent buying opportunities.

Accordingly, Merrill Lynch has upgraded its position on the basic resources sector to neutral on the back of its weakness. The bank attributes its upgrade to its mining team’s upgrade to commodity prices, and “pockets of cheapness”, such as within the mining sector. Its mining team has upgraded aluminium (+19%), copper (+20%), nickel (+45%), thermal (+21%) and hard cooking coal (+28%).

In terms of cheapness, in a research paper published on September 5, Merrill Lynch states that on a straight price/earnings (P/E) basis, basic resources, of which mining represents more than 50%, is the third-cheapest sector on a 2008 estimated P/E of 9.7 versus the market at 11.7 times, with a dividend yield of 3.8%.

Axa’s Dautresme is wary of the future performance of the materials and mining sectors, however, fearing that they are heading for a period of heightened volatility. Consequently, he will avoid high beta stocks, but remain bullish on IT, because of the sector’s cash-heavy structure and the strong American reporting season.

Karen Olney, chief European strategist at Merrill Lynch, says healthcare and insurance are cheap, while – like Bolton – dismissing concerns about the severity of the American credit crisis. She says: “We haven’t seen a collapse in earnings other than in distinct pockets tied to the credit bubble.” She points to positive indicators, such as large caps’ retained access to cheap money, together with the fact that markets have already fallen by €830 billion by the end of August, as strong defenses against investors’ equity worries.

Furthermore, in a research paper published on August 30, Olney reveals that European equity markets are actually trading in line with their 25-year average, and suggests that even if earnings per share growth fell to a negative 5% between the end of August 2007 and the end of 2008, next year’s P/E would be only 13.9 times.

Richard Batty, global investment strategist at Standard Life Investments, warns that central banks must now co-ordinate interest rate cuts to manage market volatility. Of course, this simply leaves unaffected parties to reel about the banks’ potential use of interest rates as tools with which to bail out over-zealous investors.