Recession won’t sink all ships

“The economy is not good; it’s a real mess in Europe right now,” says Paul Musson, head of the Ivy Funds team at Mackenzie Financial Corp. in Toronto and co-manager of Mackenzie Ivy European Class fund. “But there just happens to be some very well-run businesses that are domiciled in Europe.”

The outlook for Europe is clouded by widespread uncertainty around the sovereign-debt crisis — specifically, when it will get resolved and what, exactly, that resolution will look like.

Most fund portfolio managers are assuming that policy-makers will take the steps necessary to contain the crisis and avoid default by a large country such as Italy or the breakup of the eurozone.

“I think every effort will be made by the central banks, the International Monetary Fund and all the different governments to try to co-ordinate and make sure this doesn’t happen,” says Parus Shah, portfolio manager of Fidelity Europe Fund (sponsored by Toronto-based Fidelity Investments ULC) in London.

Even if policy-makers aren’t able to resolve all of the issues immediately, it’s critical that investor confidence be restored.

“The market is looking for some sort of a safety net in the short term,” says Luc de la Durantaye, first vice president, asset allocation and currency management, with CIBC Asset Management Inc. in Montreal.

Shah expects policy-makers to make progress within the first three months of 2012, noting that both Italy and Spain have to refinance a substantial volume of debt — 113 billion euros for Italy alone between January and March.

If there’s not enough confidence among investors by then to facilitate the successful sale of that debt, he says, things could go downhill very quickly. Furthermore, the longer the crisis continues, the greater the toll it will take on consumer and corporate confidence.

Assuming the crisis is addressed, fund portfolio managers expect real gross domestic product in the eurozone to decline by 0.5%-2% in 2012. The downturn will be fuelled largely by austerity measures as governments tackle their ballooning debt loads by cutting spending and increasing taxes.

These measures are expected to drive up unemployment to levels “well above 11%” from 10.3% in November, according to Martin Fahey, head of European equities with I.G. International Management Ltd. in Dublin, which will hamper consumer spending. “It’s hard to be positive on the outlook for growth against that environment because consumer expenditures still make up 60%-plus of most economies,” says Fahey, who manages Investors European Equity Fund.

Corporations will feel the impact of weakening consumer demand. Earnings are likely to decline by about 10% this year, predicts Toronto-based Stephen Way, senior vice president at Toronto-based AGF Management Ltd. and portfolio manager of AGF Global Equity Class fund.

A drop in loan availability will also exacerbate the downturn. Many European banks have to increase their capital levels, which will force them to scale back lending — and that has raised concerns about a possible credit crunch. “If you look at the lending intentions of the European banks right now,” Way says, “they are suggesting that a contraction is certainly coming.”

As the eurozone’s economy sinks, portfolio managers anticipate the euro will decline as well. In fact, some suggest it could fall below US$1.20 this year. But that’s not bad news because it will make European exports more competitive.

Portfolio managers expect the European Central Bank to support the economy by continuing to reduce interest rates in the months ahead. With rates low already, however, fund portfolio managers aren’t convinced that further cuts will have much of an impact.

They expect the ECB will eventually use quantitative easing — the purchasing of financial assets by central banks, which injects more liquidity into the system — to offset the effects of austerity measures despite resistance from Germany. Many portfolio managers are dismayed that the ECB hasn’t been more proactive in its use of monetary policy. “It’s been disappointingly slow,” Way says.

Meanwhile, Britain’s economy is expected to avoid a recession narrowly in 2012. Fund portfolio managers are anticipating sluggish growth of no more than 0.5%. Although Britain carries a hefty debt load, it’s in slightly better economic shape than the eurozone, partly because the Bank of England has been more stimulative than the ECB.

The key for investors in this kind of uncertain, slow-growth environment, Way says, is to “be selective, both at the country level and at the stock level, focusing on companies that have strong balance sheets, low levels of debt [and] are cash-generative.”

Fund portfolio managers generally favour defensive sectors, such as health care, telecom and consumer staples. But even within these sectors, they’re taking a close look at each company’s fundamentals before investing.

In the telecom sector, for example, Shah likes Britain-based Vodafone Group PLC — a global brand with stable earnings and an attractive dividend yield. However, he’s wary of investing in domestically focused companies such as Telecom Italia SpA, which is likely to suffer as the local economy enters a recession.

Within the health-care sector, Way favours Switzerland-based pharmaceutical company Roche Holding AG, which has developed a strong franchise in cancer drugs. He says the company is undervalued and has strong growth prospects.

Most portfolio managers urge inves-tors to steer clear of European companies that are reliant on the domestic economy. “The domestic market will be facing a lot of problems and retrenchment,” says Simone Loke, vice president and director at TD Asset Management Inc. in Toronto and lead portfolio manager of TD European Growth Fund.

“Consumers not spending, companies not hiring, companies not spending domestically,” she says, “because the market is shrinking or demand is not strong. The theme for companies to actually sustain their survival is to go outside [of Europe].”

Portfolio managers especially like European consumer discretionary and consumer staples stocks that have overseas exposure, particularly in emerging markets.

For example, Way’s AGF fund invests in British American Tobacco PLC and Belgium-based brewing company Anheuser-Busch InBev NV, both of which generate a high proportion of their sales from emerging markets.

Matt Moody, co-manager of Mackenzie Ivy European Class fund (sponsored by Toronto-based Mackenzie Financial Corp.), is partial to consumer products company Unilever PLC, which has head offices in both London and the Netherlands. Unilever is a high-quality company with a diversified portfolio of brands and a significant global presence, Moody says: “Over half [Unilever’s] sales are in emerging markets. [It’s] almost literally everywhere on earth.”

Adding to the appeal of these multinationals — especially in the consumer staples sector — are fairly strong dividend yields of about 3%-5% and the likelihood, given the strong growth prospects of these global companies, that their dividends could rise.

“Most of these companies are going to be bigger five or 10 years from now compared with today,” Shah says, “so you know your dividend is getting bigger.”

Most portfolio managers are steering almost entirely clear of European banks, due to their direct exposure to the sovereign-debt problems, but their funds continue to hold shares in non-bank financial companies such as insurance companies and asset-management firms.

Loke prefers IG Group Holdings PLC, a London-based financial derivatives trading firm. It has fairly stable earnings that are generated from commissions and interest, and it offers a niche service. “Their earnings are relatively resilient,” she says. “On top of that, it’s a growth market of individual investors that’s not catered to by full-service and discount brokers.”

If the financial crisis in Europe takes a turn for the worse, however, portfolio managers say they’d be quick to get rid of almost any exposure to the financial sector. They’d also cut back their holdings of industrials, materials and mining stocks while adding more defensive plays, such as health care and consumer staples.

Regionally, many portfolio managers’ funds have large positions in Britain, partly because that country is home to many global corporations.

Other countries in which the European funds currently have overweighted positions include Switzerland, Germany and the Scandinavian countries. In contrast, there generally is little or no exposure to Portugal, Italy, Ireland, Greece and Spain — the so-called PIIGS — because the outlooks for those economies are far less promising.

Looking ahead to 2013, some fund portfolio managers expect to see a return to economic growth. “Assuming things don’t get worse,” Loke says, “you will see some sort of technical rebound in 2013.”

But don’t expect any sort of momentous recovery in the economies of the European nations. It probably will take the peripheral countries many years to reduce their debt loads, and economic growth is expected to suffer as this process runs its course.

“The debt situation has to be addressed,” says de la Durantaye. “It’s going to be an environment in which economic activity will still probably be very weak in Europe in general. [And that] will impact the whole investment environment for the next five years.” IE