Edmond de Rothschild compares the macro and the microeconomic pictures

Today’s market environment is tricky, note Philippe Lecoq (pictured) and Olivier Huet at Edmond de Rothschild. Volatility is high and investors are expecting the worst: sovereign defaults in Europe, a double dip in the US and weakness in the banking sector.

This has all led to severe tensions on stock markets. And yet, the microeconomic picture ­contrasts sharply with the current macroeconomic ­situation.

In Europe in particular, companies are enjoying excellent fundamentals such as historically high margins, robust balance sheets and abundant liquidity.

After an upbeat performance since the autumn of 2010, economic data in the latest quarter pointed to a worrying downturn.

In Europe, growth in the eurozone slowed from 0.8% to 0.2% in the second quarter and Germany’s performance even fell to 0.1% compared to 1.3% in the first quarter, which itself had been revised down from 1.5%.

As in the summer of 2010, investors began to focus on the risks of a possible double dip. 

In Europe and emerging countries, heads of companies expect to see further slowing in the economy, but to what extent is still unsure. In 2011 and 2012, the US and Europe should see growth of less than 2%.

The eurozone is confronting distinct problems linked to sovereign debt, institutions and financial systems, but their effects have all come together.

Finding a solution to the sovereign debt crisis has been delayed because institutions are unprepared and not strong enough. The second Greek rescue plan has still not been satisfactorily settled.

The new-look stabilisation fund, the European ­Financial Stability Facility, will probably not be up and running before the fourth quarter and its current €440bn war chest would not be enough if Spain or Italy (€1.8trn or 119% of GDP) were to need bailing out.

To date, there is still investor concern that both Italy and Spain might not honour their debt commitments, but it will take time to assess moves by the Spanish and Italian governments to reduce their public deficits.

In the meantime, the ECB is the only real operational institution and its intervention on secondary markets has helped curb soaring interest rates on Italian and Spanish debt.

Whatever markets might think, Italy is not Greece and it has a primary fiscal surplus. Similarly, Spain managed annualised growth of 0.7% despite cutting the public ­deficit in the past 12 months from 11% to 6% of GDP.

This lack of visibility immediately hit the European banking sector. Short-term bank funding has become more expensive, but covered bonds are still being issued and the ECB continues to guarantee liquidity in the system, including dollar funding.

Sectors with visible dividend streams, such as healthcare, telecoms and oil majors, offer secure shareholder returns that are largely independent of economic and market conditions.

High payouts and low stock prices have resulted in average dividend yields of more than 7% and even 9% for telecoms.

This compares with safe sovereign bond yields of 2% and 4.5% for European ­corporate bonds as a whole.

Today’s situation on stock markets is totally unlike that of 2007 and 2008. First, companies are in excellent shape and sitting on surplus liquidity.

Second, they desperately need to make acquisitions as organic growth alone will not be enough to maintain profitability and competitiveness.

Moreover, many companies no longer depend on bank financing, which is why they have been largely unaffected by recent events.

They are now in a position to make acquisitions without needing to secure additional credit lines.

Although the current cycle kicked off in June 2010, the really big recovery in European M&A deals started at the beginning of 2011.

The first nine months of 2011 saw an increase of 39% in value. The ­current M&A cycle has slowed in pace because short-term visibility is poor, but everything is still in place for a new leg in the cycle.

Consolidation can be seen in several ­sectors from luxury goods to chemicals. In IT services, hardware ­companies are looking to focus on services to remain competitive.

Less orthodox moves could also have a ­positive impact on the market. Exposure to emerging country growth provides ­European companies with genuine leverage.

The emerging zone represents an increasing share of their business: 28% of sales, 27% of operating profits, 50% of sales growth and 32% of asset values.

Moreover, exposure to emerging countries through European companies rather than directly allows investors to combine high quality ­governance with dynamic growth.  


Philip Lecoq is co-manager of European equities, and Olivier Huet is European equity fund manager at Edmond de Rothschild Asset Management.

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