Is “core” Europe stalling?

19 August 2011

Germany, as Europe’s largest economy, is considered the powerhouse of the eurozone and its economy had been flourishing. However, the latest figures show Germany’s economy may be struggling. Germany’s economy only expanded 0.1% in the second quarter, well below expectations for 0.5% growth from the previous quarter.

Second-quarter GDP figures from France were equally disappointing. The country failed to record any growth at all in the second quarter, dashing expectations the eurozone’s second-biggest economy had expanded 0.3% over the three months. Of concern to investors is that France’s economy is spluttering before austerity measures have been enacted.

What are the ramifications?

It appears “core” European countries are undergoing a much deeper-than-expected slowdown. The question remains: If the eurozone core economies flounder what will prop up the periphery economies? The poor results fed into the low second-quarter GDP figure for the 17-strong eurozone. A report on August 17 showed the euro-area only grew 0.2% in the three months ended June.

Generally, data for Germany and France has been soft across the economy – manufacturing, which rebounded strongly after the recession, has waned in recent months, as the chart below shows.
This raises the possibility that the eurozone will enter a recession, which would knock global growth and hamper the ability of governments across the continent to fix their finances.

The disappointing data makes the European Central Bank’s two recent interest-rate hikes, which boosted the cash rate to 1.5%, seem ill-timed to say the least.

The second-quarter GDP results for Germany, France and the eurozone appear to rule out more rate increases, even if inflation is above the bank’s 2% threshold. There is debate about whether the central bank should reverse course and reduce interest rates back to 1% – the bank was forced to do such a U-turn in 2008.

But it is not all doom and gloom…

Current valuations on European equities have already priced in a significant slowdown in economic growth (possibly recession) to such an extent that many good-quality European stocks may represent excellent value.

Even in a slow-growth environment, companies that are market leaders in their field, have maintained strong balance sheets and delivered strong returns on capital are likely to outperform their peers.

“There are structural trends which will support global growth and individual opportunities. In pursuing these opportunities, I see that German companies are well placed given their healthy balance sheets and strong competitiveness as evidenced by unit labour costs, brand strength and innovation,” says Christian von Engelbrechten, Portfolio Manager German equities, Fidelity.

“There is a lot of uncertainty as to the future course of events but this is to a large extent getting reflected in stock prices. On long-term trend earnings, the European market is trading on 10-times earnings. The only other period in recent times that the market was this cheap was back in the early 1980s when bond yields globally were significantly higher,” says Parus Shah, Portfolio Manager European equities, Fidelity.

PMI manufacturing for Germany and France

Bloomberg. 16 August 2011