European equities have just finished a horrible third quarter, declining by almost 17%. Given the fact that we see a higher than 50% risk of a mild recession in the UK and the eurozone in the coming quarters, we think this decline is justified. After all, even in a mild recession, corporate earnings will fall at least 5 to 10% in 2012. Investors have already largely discounted this specific scenario, but the ongoing uncertainty around the euro crisis allows for an unusually vast range of outcomes.
How should investors in European equities deal with this environment?
Firstly, they should realise that, as a result of the euro crisis, many companies are struggling tot get sufficient access to bank credit. This is especially true for smaller and medium sized enterprises. Furthermore, these companies now also find it harder to fund themselves via the corporate bond markets, where new issuance and trading volumes have declined dramatically. Conversely, large multinationals have much less problems to access credit markets, giving them an advantage in these market conditions.
Europe appears less well positioned to adapt to an increasingly globalised, competitive world than the Americas or Asia. Our labour markets are more rigorous, our retirement schemes more burdensome and our unions more powerful, especially in the southern countries
Secondly, Europe appears less well positioned to adapt to an increasingly globalised, competitive world than the Americas or Asia. Our labour markets are more rigorous, our retirement schemes more burdensome and our unions more powerful, especially in the southern countries. In the past, these three relative negatives have been masked by the “credit super cycle”, the abundant availability of cheap money. Now, with debt levels high and political unity (in the euro zone) elusive, European citizens may face a multi-year period in which their purchasing power is eroded. In this respect it appears that globally oriented European companies will be better positioned going forward than domestically oriented ones.
Thirdly, in an environment where access to new cash is increasingly difficult, the solvency and liquidity situation of a company becomes more important. Companies with strong balance sheets and the ability to generate stable free cash flows are less dependent on banks and financial markets for the continuity of their business. This profile is most commonly found among large, well diversified companies in business sectors which are not too cyclical in nature.
In all the observations mentioned above it becomes clear that large, globally oriented European companies in defensive sectors should be best positioned to adapt to the more difficult business environment which lies ahead of us. The small and medium sized companies will face more headwinds, as they tend to be more cyclical and more domestically oriented. These companies are also likely to experience more funding problems as long as the European banking system and corporate bond market experience ‘euro stress’.
Reflecting this issue, we have recently seen European small cap companies underperforming their larger brethren. We think that this trend will continue, reversing a period of almost ten years in which small caps performed better than large caps. In the period ahead investors should think big, focussing on large companies with fat balance sheets and generous dividends. And they may well have to keep “thinking big”, certainly as long as some policy makers and union leaders do not.
