Last week Europe entered a Boom phase in our Quant team’s style cycle model; driven primarily by rebounding PMIs and rising bond yields. At the same time, EM data are soft and investors’ fears of a China hard landing are growing. Even with the US on the road to recovery and EU data starting to turn, investors wonder whether a slowdown in EM will ultimately destabilise Europe.
In a new report from John Bilton, CFA, European Investment Strategist, BAML, John asks and examines the question ‘Can Europe Go Boom If China Goes Bang?’
During the EU crisis investors avoided domestic stocks and financial sectors but, perhaps surprisingly, bid up some cyclical sectors alongside quality and defensive growth plays. Exposure to EM growth, particularly China, was the common thread across sectors as diverse as Staples, Mining, and Cap Goods. In some cases, e.g. Mining, slower EM demand is already apparent in price action; but in other cases slower EM growth is not yet fully reflected. We believe that, on aggregate, EU equities can shake-off softer data in EM given that the EU domestic demand outlook is stabilising. However, EM exposed stocks are likely to be vulnerable to downgrades just as momentum in EPS revision ratios elsewhere is picking up.
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Risks are shifting: from stocks to bonds, and from DM to EM
For much of the last five years, investors were able to take shelter from various economic and market tempests in a few axiomatic ‘truths’ – bonds were safer than stocks, EM growth was superior to DM, and liquidity was omnipresent. The last few weeks have seen all of these assumptions tested, and come up wanting.
Against this backdrop it’s perhaps surprising that European stocks are down just 7% from their highs. While Bernanke’s confirmation that QE will eventually be tapered led to turbulence across markets, the main fall out was in FX and rates.
The 4 std. dev. jump in rates volatility dwarfed the rise in VIX (chart 2) implying that for the first time in 5 years bonds, not stocks, were at centre of the storm. But as the market regained its poise, peripheral bond spreads quickly rallied and current spreads vs. bund are back near their lows (chart 3).
At their low point, immediately after the tapering announcement, EU stocks were 12% off their May highs. The subsequent 5% rebound was helped along by upside surprise in European data, with the soft China data seemingly shrugged off. The net 7% decline leaves EU equity on a level consistent with the kind of move we’d expect around a first rate hike as opposed to a simple shift in Fed language (chart 4). Our rates strategists estimate that short end EUR rates tightened ca. 50bp and there is ample room for this to reverse as the recent turmoil in rates markets calms down. We believe that this will prove supportive for EU equity markets and will reinforce with the improvement in consumer and manufacturing confidence that we’re starting to see from the Eurozone (chart 5).
Clearly slower data in EM is a headwind for European markets, but in our view the stabilisation of domestic data, and the reversal of the over-reaction to the tapering announcement, probably dominate for the time being.
Assuming we are correct in our view, and the stabilising domestic picture dominates a softening EM outlook, then it raises two questions: 1.) How much of a slowdown in EM/China can Europe withstand before the economy here is affected? And 2.) Which sectors and stocks are most exposed to slowing EM/China data and recovering EU data? How bad can it get in China before Europe suffers?
Hard Landing Of China Could Affect All Economies
A genuine hard landing in China would likely have negative ramifications for all global economies, but we believe that Europe can take a modest slowing of Chinese growth in its stride. Our China economist, Ting Lu, believes that while there may be some downside risk to Chinese data, the risks of a hard landing are overstated and he sees real Chinese GDP growth of 7.6% in 2013. Nevertheless, in the last few years strong EM demand helped Europe’s main exporting economies (Germany, Sweden, etc) to weather the EU crisis. The result was DAX and OMX trading close to their all time highs, while other EU indices languished as the domestic demand picture remained bleak. However, the most palpable pick up in data and sentiment is coming from the periphery – albeit from a low base – and it is domestic EU demand that is now driving EPS upgrades.
In our view, the pick up in domestic demand can offset softening EM/China demand for Europe’s key exporting nations as well as providing a broader tailwind for EU equities. We are seeing this pattern begin to show in industrial data with German PMIs moderating just as French and Periphery PMIs rebound (chart 6). The pattern extends to EPS revision ratios (chart 7) where Italian and Spanish EPS revisions are now leading broad European ERR.
While we are encouraged by the pick up in demand in Europe we would be the first to concede that any European recovery is going to be muted; and in comparison to EM growth trends will be positively anaemic. Nevertheless, equities tend to respond most powerfully to changes in trend and to data surprise.
Europe’s Share of Global Consumption
Like most developed economies, consumption is the largest component of European GDP. Europe’s share of global consumption is four times that of China, from a population that is only 40% of the size; given the much larger base, a modest pick-up in EU consumption can offset a much more meaningful percentage decline in Chinese growth.
As a result a modest improvement in EU consumer sentiment can have an outsized impact on growth expectations, and by extension on EPS and stock prices. Chart 8 shows that even though consumer confidence remains solidly in negative territory, the trend is rebounding strongly, and is led by Italy and Spain.
The forward looking components of PMIs also point to further improvements in coming months (Chart 9). So even though European policy makers can only dream of the kind of growth rates we’re used to seeing in China, it’s