Gray Clouds Over the Eurozone

While Europe's markets have held up strongly, an S&P equity strategist says concerns about its economy aren't going away

Despite some trepidation among market observers that the impressive gains racked up by European indexes in 2005 would fall off in the new year, they've held up rather well. The S&P Europe 350-stock index is up 6.5% on the year (through Feb. 22).

Count Clive McDonnell, Standard & Poor's European equity strategist, as one of the doubters. In December, he noted that the markets could be stung by rising interest rates, among other factors (see BW Online, 12/08/05, "No More 'Easy Money' in Europe"). And while European stocks have proved resilient, a recent report by McDonnell points out another potential negative for equities in coming months: rising dividend payout ratios -- the percentage of a company's earnings that it pays in dividends. S&P forecasts a weighted average payout of 43% for companies in the index, up from 41% in 2004.


  Why is more money paid to shareholders such a bad thing? McDonnell says increasing payouts could indicate that in sectors such as telecoms and utilities there are far fewer chances for companies in these groups to increase their existing businesses. Still, this does not necessarily guarantee a stock slump, as McDonnell says, even where there is a direct effect on corporate performance, "Investors can overlook variables for a prolonged period of time."

McDonnell recently spoke with BusinessWeek Online reporter Alex Halperin about why big dividends aren't necessarily good investments for companies, and developments that could trigger a market decline. Edited excerpts from their conversation follow.

Do you see it as an indication of growth ahead that investors have seemed willing to invest in sectors that have cut dividends?

I think it is for those sectors but the issue is that they are in a minority. The other sectors in the market are raising their dividends due to fewer long-term growth opportunities for the majority of the market.

Is there a notable shift between these two types of sectors than how investments have been made in the past?

The point is that in terms of performance last year, those sectors that cut their payout ratios were among the top performers, whereas those that raised, such as telecoms and financials, underperformed the market.

Do you see this as a symptom for there being a lack of organic growth opportunities for European companies?

Absolutely. That's why we're seeing a lot of M&A activity as companies try to buy growth.

Why is there a lack of organic growth opportunity?

One of the issues is the very disappointing performance of the eurozone economy. That's nothing new but what companies have been doing is investing overseas and looking for growth opportunities in emerging markets, and they have been successful in that, whether it's in the U.S. or in Asia.

But we're sort of now coming back to the same problem that overseas growth is certainly important, but how come we can't get the domestic economy within the Eurozone moving? That is the crux of the issue.

Looking at the sectors paying greater dividends, what are some of the characteristics of each?

If you look at the ones that are raising the payout ratios [dividends as a percentage of earnings], such as telecoms and financial sector, they are fairly easy to analyze. In financials we've got changes associated with the new capital adequacy ratios coming in and that's freeing up capital, allowing banks to return more to shareholders. There's a structural change taking place.

In the telecoms sector, it's fairly clear that there is a problem with regard to longer-term growth. One of the main things management is doing is increasing the amount of cash it returns to shareholders. The companies are continuing to underperform because investors are effectively derating the sector. In utilities, historically it has a high payout ratio. But we're seeing even more, but that's probably a cyclical development.

Would you be more bullish if you saw lower payout ratios?

I think yes. If in 12 months we were to see companies cutting their payout ratios I would view that positively, as that would signal that there are increasing investment opportunities. The situation could change, but if we look at capex [capital expenditures] as a proportion of sales it's in a downturn; it's not just one year's data that have been our source of concern.

We've seen it develop into a trend over the last four or five years, and it just accelerated dramatically last year. And also it's a contrast to America where companies reduced their payout ratio from 33 to 32%.

Why is the situation so different?

I'm not an expert on the U.S., but I think one interpretation is that there are attractive long-term investment opportunities in the U.S. economy and internationally for U.S. companies.

More generally speaking, so far [in 2006] the market has bucked S&P's bearish outlook. What developments would make you more optimistic?

If we were to see a drop in inflationary pressures in the eurozone, if we were to see the ECB leave rates where they are as opposed to further raising them, if the guidance from companies were more upbeat, and we were to see analysts forecast a change in the payout ratios into 2007, into 2008, that certainly would result in a change in my view.

But if we look at what U.S. companies have been saying recently, [their concerns] about the rise in interest rates and the impact it will have on the consumer sector, the U.S. is a picture of what, based on available information, could be facing European companies 12 to 18 months from now. In other words, as rates rise they act as a drag on corporate performance.

The U.S. equity market has gone sideways over the past 12 to 15 months reflecting concern over that, but the market has already discounted it. We're loosely expecting a similar trend in Europe.

It's true that the market doesn't share our view. The market is a lot more optimistic. What we need is a catalyst for our concerns to materialize. If we see the ECB raising rates in the next month, in early March at their meeting, I think it would focus attention on the upward pressure on rates.

Also, [regarding] the earnings season, in Europe only about a third of companies have reported, whereas three-quarters in the U.S. have reported. So if we see more caution from European companies, that could act as a drag as well.

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