Money managers are forecasting a modest pickup in economic growth in Europe in 2006 fuelled by the need to cut costs and restructure in order to remain competitive against the low-wage new entrants to the European Union.
There are 10 eastern European countries nearing the two-year anniversary of their admission into the EU. They comprise an area of almost 75 million consumers and boast significantly lower labour and manufacturing costs than their western European counterparts, as well as business-friendly corporate tax rates.
As a result, money managers are optimistic that the aggressive cost restructuring taking place at many western European companies will propel Europe’s GDP growth to 1.8%-2% in 2006, vs the slightly less than 1% growth seen across the continent in 2005. They’re also expecting Britain to hold steady at 2%.
“Europe, where it is today, is increasingly a thematic story,” says Manraj Sekhon, director of international funds at Henderson Global Investors Ltd. in London. “It’s a story of restructuring and a move toward a greater focus on shareholder returns and profitability. Therefore, it’s a theme that straddles a number of sectors and potentially a number of countries.”
Corporate Germany appears to be leading the way. “Germany has a greater understanding of the threats and risks posed by competition in eastern Europe and elsewhere,” Sekhon says. “As a result, German companies have had to cut costs, reduce labour costs and be more flexible in the way they run their businesses.”
He cites Siemens AG as an example of a business that has cut its workforce and arrived at more flexible arrangements with its trade union.
“The addition of new members to the EU has opened up a whole other area of lower-cost labour to which many companies can outsource. And that’s really quite a catalyst for change in corporate restructuring, especially in Germany,” says Greg Gigliotti, managing partner at Trilogy Advisors LLC in New York.
Europe, however, still faces significant hurdles, largely because of demographics and a monetary policy that focuses solely on price stability and doesn’t consider the implications for economic growth.
The aging population is a major issue. European retirees will outnumber workers in the next 15 to 20 years, resulting in explosive growth in the health-care sector as well as an expected move to opening doors to neighbouring European countries in order to meet rising labour demands.
In addition, “there hasn’t been a clear resolution on a number of issues, including the labour market, interest rates and politics,” says Sekhon. “Therefore, it’s been difficult for consumers to go out and spend with confidence. So until we get past this situation, it’s unlikely we’re going to see a very strong and pronounced recovery, in economic terms.”
Nevertheless, there are opportunities, says Anthony Eagleton, a bottom-up equity product specialist at HSBC Halbis Partners in Paris. He believes European stocks are undervalued compared with U.S. equities because investors often think the best opportunities lie in fast-growth areas. “But higher GDP growth doesn’t necessarily mean high stock market growth,” he says. A lot of the growth in places such as the U.S. is built into current valuations, so countries with good growth are generally expensive.
Gigliotti also finds European equities cheaper than global alternatives. “We’ve seen an evolution in which the valuations have actually gotten cheaper in Europe as the market has gotten stronger,” he says, adding that this is indicative of the improvement in European growth.
Britain is underrepresented in Gigliotti’s portfolio. The country is struggling for growth, he says, and will probably see interest rates under pressure this year. But he is significantly overweighted in Germany (names include Commerce Bank AG, Allianz AG and Bayerische Motoren Werke AG [BMW]), Switzerland (Nestlé SA and Swatch AG) and Norway, where he’s found several strong performing energy stocks.
Telecommunications is an area in which Eagleton is finding attractive companies that have stabilized their costs through consolidation and benefited from expansion into eastern European markets. Such players include service provider Elisa Corp. in Finland and mobile phone operator TeliaSonera AB in Sweden.
Eagleton also likes a number of consumer-product companies that have a high barrier to entry, including German-based luxury names such as PUMA AG, Hugo Boss AG and BMW. “These are companies whose names will allow them to stay ahead of competing brands,” he says.
@page_break@Sekhon is also finding opportunities in companies that stand to benefit from corporate cost-cutting. The move to reduce the number of permanent employees in large businesses, for instance, plays directly into the hands of Randstad Holdings NV, a Dutch company that provides temporary employees to corporations in Germany and the Netherlands. Temporary staffing accounts for 2.5% of the workforce in the Netherlands and less than 1% in Germany, vs 5% — and growing — in the U.S. and Britain, providing a tremendous opportunity for growth, Sekhon says. He is also overweighted in health care, consumer staples and energy, and underweighted in consumer discretionary and telecoms.
Sekhon and Eagleton are also finding good names in the financial sector, particularly those with exposure to eastern Europe — where there is a significantly lower penetration of mortgages and credit.
“If a bank can establish a foothold in countries in which deposits are going to grow, then we’re going to take advantage of that,” says Eagleton. But, he cautions, not all financials are attractive right now. “Most European banks have been benefiting from the real estate boom for the past couple of years, and that’s going to die out in the mature markets. However, it’s only going to begin in countries such as Poland and Hungary,” he says.
Less enthusiasm
Gigliotti thinks Germany, which hasn’t been part of the real estate boom, will also see a rise in real estate values. He says a legislative change in Germany could result in the same real estate investment trust structure found in the U.S., creating a whole new source of liquidity for companies looking to be more efficient in how they manage their capital.
As for materials, energy and industrials, there’s less enthusiasm for these sectors. Shaun Hegarty, vice president of EAFE equities at TAL Global Asset Management Inc. in Montreal, for one, feels these are risky pockets of the market. And just as there was during the peak of the dot-com bubble, there’s an “irrational exuberance” surrounding companies that sell copper and iron, for example. “We think, to some extent, that there’s a bit of an accident waiting to happen,” he says.
The bottom line is that most of the industrials and materials are demonstrating neither growth nor attractive valuations, he adds. At present, he’s overweighted in financials (Royal Bank of Scotland International Ltd.), health care (Roche Holdings AG in Switzerland) and consumer staples (Carrefour Group in France).
Gigliotti, who expects oil to stay at about US$50 a barrel, is worried about utilities as well as industrials. “We’re seeing a lot of pressures on utilities and on the cost structure of industrials, which are big consumers of energy, whether it be aluminum companies, fertilizer companies or any of the energy-intensive industries,” he says. “We expect that to continue.”
Another question mark is the euro, which sank 13% against the U.S. dollar in 2005. Fund managers are finding it difficult to predict its direction, and most are hedging their portfolios with investments in global companies that have just as much exposure to the U.S. as they do to Europe.
Gigliotti feels that many European companies have begun to adjust to the high euro. “It’s been difficult, obviously, on the exporters, but what’s happened is people have gotten used to it,” he says, adding that there will probably be more adjustment to come as he expects more downward pressure on the US$ over time. IE
Europe to see modest growth
- By: Lara Hertel
- January 30, 2006 January 30, 2006
- 11:00