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.
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.
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
probably fair to say that EM equity investors would much prefer the direction of the trends we’re now seeing in European data.
While Europe, like the US, is a consumer led economy, the picture is quite different in China. Over the past three decades, China has invested heavily in infrastructure, becoming the second largest contributor to world investment.
World Bank’s Data Investments From China
According to data from the World Bank, 17% of global investment in 2011 came from China, compared to 15% from the Euro Area, and 20% from US. While contributions from US have stayed flat between 1980 and 2011, Chinese contributions increased 17-fold. Relative to its own GDP, China invested 46% in 2011 compared to the world average of 19%. This upward trend in investment and downward trend in consumption accelerated post-2000, and caused the two GDP components to converge (chart 10).
In our view, the trends in investment and consumption in China are probably not sustainable. One of the key components of the 2012 five year plan was to shift the country away from infrastructure and export led growth, and more towards domestic consumption and inclusive growth. Such transitions are seldom smooth, but with traditional investment experiencing diminishing marginal returns there is a clear impetus for policy makers to attempt to seek to rebalance the economy.
According to our economists, the efficiency of fixed asset investment has fallen over the past few years. The incremental capital-output ratio (ICOR) suggests that in 2012, 6 units of capital were required to produce 1 unit of output, compared to the 3 units in 1991 (Chart 11). So while investment has increased, each unit of investment is less productive and as a result will contribute less to the final GDP number.
Some of this negative outlook is already reflected in market sentiment. Consumer confidence has fallen sharply and is near all-time lows. Manufacturing confidence meanwhile has yet to see such violent moves, but the trend is declining with PMIs hovering around the break-even reading of 50 (chart 12). There is some risk that this data series dips into contractionary territory if the decrease in productivity materialises further in China.
But even if data in China risks declining further it is likely to be less of a surprise to investors than the converse run of positive data in Europe. According to the June Fund Manager Survey investor confidence is declining in China. A net 32% of PMs identified China as the ‘biggest’ tail risk, overtaking Eurozone risk for the first time (chart 13). While PMs are not yet at the crescendo of negativity over China that we saw towards Europe and US during the peak of their crises, the slowdown in Chinese data is hardly new news. Positioning though is already at extremes in several China linked asset classes. Allocation to commodities are at their lowest point since Dec-08 and is within a whisker of all time lows; and the EU mining sector is the worst performing sector on a 1m, 3m, 6m and 12m basis.
The combination of Europe stabilizing from a low base, the wash-out already seen in some of Europe’s China proxies, and acknowledgement of the downside risks to the Chinese data likely mean that EU equities can withstand some further slowing in China. The IMF estimates that China share of global GDP is half that of the US and equal that of Germany, France, and Italy combined.1 At present, consensus estimates for China GDP growth are 7.7% and 7.3% for 2014 and 2015 respectively. Given the relative size of the economies, a 100bp drop in Chinese GDP could be offset by 33bp of upside GDP surprise across US and selected European nations. Nevertheless, Europe’s EM exposed stocks will suffer disproportionately and we are beginning to see EPS downgrades in such sectors.
Which sectors and stocks may be more vulnerable?
The contrasting change in sentiment between EM and domestic EU is beginning to show up in EPS revision ratios. Among European stocks, those with domestic EU exposure are seeing ERR rise while those with EM exposure are seeing ERR fall (chart 14). The ERR for stocks with EM industrial exposure is falling more sharply than for those with EM consumer exposure. This is beginning to manifest itself in the valuation differentials between EM and Domestic exposed stocks in different sectors. Among EU industrials, the premium of EM vs. DM exposed stocks recently declined quite sharply. By contrast for Staples the premium of EM exposed names vs. DM exposed remains near its highs (Chart 15). The pattern appears in somewhat in conflict with the relative moves in Chinese industrial and consumer confidence (Chart 12) and may imply some derating risk yet to be realised in the EM exposed EU consumer stocks.
At a high level, rising EU domestic ERR trends and falling ERR trends for EM exposed stocks reinforces our strategic preference for EU domestic sectors. But delving deeper, the sectors with the greatest EM exposure (based on revenues) are Tech, Food & Bev, Basics, PHH and Chemicals (chart 16). Of these we have a strategic UW recommendation on Food & Bev, PHH and Chemicals, and are strategically Neutral on Tech and Basics. In our view, price action in sectors like Basics suggests that fears over China/EM data are already quite will reflected.
However, in some of the consumer geared sectors, notably PHH, recent price action has been more positive and suggests some vulnerability to any deterioration in China/EM consumer sentiment. By contrast, the EU sectors with the lowest EM exposure are Utilities, Financial Services, Insurance, Travel & Leisure, Media and Banks. We have a strategic OW on Travel & Leisure, Media and Banks, and are neutral on the other three. Our tactical framework (a 1-3 month statistically derived trading signal) has both Utilities and Insurance registering a short term bullish signal (link).
European Union VS Emerging Markets
Stockpickers may chose to play the domestic EU vs. EM/China theme by pairing a short in EM exposed stocks with poor ERR but high valuations vs. domestic EU exposed stocks rising ERR and undemanding valuations; charts 18 and 19 show a quantitative screening of the more and less attractive EM and domestic EU exposed stocks. Several EU Staples and Industrials
names are still showing up in the less attractive quadrant on these metrics, suggesting that even at a bottom up level these sectors may be vulnerable to deteriorating EM data.
This reinforces the tactically bearish signal on both sectors that we picked up this month from our Sector Tactical Conviction (STC) model. By contrast, given the derating and the low EPS expectations of EU exposed stocks, many sit in the ‘more attractive’ quadrant. We believe the positive momentum in these stocks can continue as forward looking components of EU PMIs suggest further improvement even if EM/Chinese data risk further deterioration. In our view, this will keep domestic EU equity sectors well supported and a relative winner over coming months.
