Optimism rides on stars in the East

The S&P Europe 350’s October rally petered out, but forecasts for economic growth remain optimistic as strong demand from emerging markets is expected to bolster economic activity.

The S&P Europe 350 index gave eurozone investors a glimmer of hope at the end of October when it drew to a close at 1596 – almost a 150-point, or 10%, recovery from its August lows.

But the mood was short-lived: by November 9 – just over a week later – the index, which tracks the performance of
equities in 17 pan-European markets, had fallen 60 points.

Nevertheless, some hope remains. The European Commission increased its 2007 GDP eurozone growth forecast to
2.6% from 2.5%, predicting strong demand for eurozone exports from emerging economies such as China to offset some of the damage being caused by the financial markets in America in the fourth quarter.

Steven Maxwell, the head of European equities at Scottish Widows Investment Partnership, shares the Commission’s optimism.

“There is a lot of focus on the US, but we should never lose sight of the fact that China and Russia are far more influential on European exports,” says Maxwell. “The US is the recipient of just 15% of European exports, so it’s important that the focus on the US is not exaggerated.”

Similarly, Claudia Starr, an analyst at Edison Investment Research, says that while there’s a 50-50 chance of a recession in America, there is only a one-third chance of it developing into a global recession because of the strength of China, Russia, India and Latin America, which according to Starr have not been factors in previous cycles.

Robert Quinn, European equities strategist at Standard & Poor’s Equity Research, says he expects mortgagerelated structured finance losses to continue for several quarters yet. In his Global Equity Strategy report published on November 10, Quinn estimated that third quarter losses represent less than one fifth of perceived total losses. He bases this on the assumption that the American mortgage market is worth $10 trillion (£4.8 trillion) and that the subprime component comprises 12% of this total, with a default rate of 30% and a severity rate of 40%, resulting in cumulative losses of $150 billion.

Quinn says that of $1.24 trillion in subprime mortgages outstanding, $700 billion was securitised and is now scattered among European banks, as well as global hedge funds.

He says: “For the market to recover, it will need to be led by financials. They represent 30% of the S&P Europe 350, so it needs an awful lot of effort from other sectors to drag it higher.”

Quinn expects to see a shift, with banks’ flight to safety becoming more a flight to simplicity, particularly in terms of disclosure – which will help disclosure.

Reg Watson, investment director of European equities at Standard Life Investments, says that some eurozone retail banks, such as National Bank of Greece and Alpha Bank, could be forgiven for questioning the existence of a credit crisis because of their successful expansion into Eastern Europe, which he considers resilient.

Starr views Italian banks as buying opportunities, particularly the country’s largest bank, UniCredit Spa. This view is also based on the good growth prospects in Eastern Europe.

She also likes Spain, and not only for its banks, which include Banco Santander – the best-performing bank in the eurozone in the past two months. She likes the growth potential for Spanish utilities, which she expects to be driven by the liberalisation of the country’s electricity network.

Franz Wenzel, deputy director of investment strategy at Axa Investment Managers, likes French banks because of their diversification across the financial services sector. He also plans to re-examine the Italian banking sector, where there is the possibility of further M&A activity.

But Wenzel rejects forecasts of 10% growth across eurozone banks in 2008.

“There is a flat yield curve and all the ingredients for minor examples of growth in the making, so 10% looks too demanding,” says Wenzel. “It’s difficult to see how the yield curve could steepen.”

Instead, he is bullish about telecoms, which have shown substantial earnings increases over the past three months, making it the best performing sector. Wenzel forecasts 13 times earnings for 2008, compared with 12 times for the total eurozone market, which he attributes in part to substantial improvements in companies’ balance sheets.

Watson makes the same observation in relation to Siemens, highlighting its recently announced €10 billion (£7.2 billion) share buyback programme as a clear commitment to capital discipline. “Corporate governance has finally caught up with the modern world, with balance sheet structures becoming leaner and more transparent,” he says.

Both Watson and Starr express concern about the renewable energy sector, highlighting technological development as a hurdle to growth. Watson says: “The values being applied to these companies are reminiscent of the dotcom era because renewables are fashionable, but there’s more money going into them than there are investment opportunities.”

Maxwell points to insurance as a sector with a lot of undervalued companies, such as Axa. Similarly, Keefe, Bruyette & Woods (KBW), a stockbroker, flags Axa as a medium-term buying opportunity owing to the growth drivers arising from its strategic plan “Ambition 2012”, such as product innovation and acquisitive focus.

KBW is bullish about the insurer’s relatively low embedded value, which is trading at 1.5 times the stockbroker’s updated embedded value estimate for an 18% 2009 return on embedded value. This compares with its history of near 1.8 times embedded value trading levels.

Finally, there is a consensus that large companies present better buying opportunities than their medium and small counterparts owing to their generally stronger balance sheets and resilience to economic volatility.