Steering Europe's Market Currents

S&P's Clive McDonnell talks about the new report on European markets, the euro vs. the dollar, risk factors, and the future

After recent tumbles, the major European stock markets are beginning to show some glimmers of life. Even so, conditions remain highly unpredictable. A recent report from S&P Equity Research highlights some of the most important risk factors for the European markets. They are inflation (including interest rate concerns), currency exchange rates and, most seriously, corporate earnings that might not meet forecasts.

Where should European investors turn in such an uncertain environment? Defensive sectors like health care and utilities might fit the bill, says Standard & Poor's chief European equity strategist, Clive McDonnell. He notes that S&P also lowered its outlook on the materials sector because of earnings risk, and that investors should get used to the euro's continued strength against the U.S. dollar.

Shortly before the Federal Reserve's June 29 interest rate rise, reporter Alex Halperin spoke with McDonnell about his sector picks, the key role of corporate margins, and why increased euro zone indebtedness isn't necessarily a bad thing. Edited excerpts from their conversation follow.

It sounds as if things are turning sour.

That sounds a little bit extreme but [market conditions] are certainly a lot more challenging.

[The S&P report] highlights three types of risks. Why do you see earnings as the most problematic?

I think it poses the greatest risk for equity prices; that's the main issue. We have seen interest rates drift up in the U.S. and in Europe and that has provided a challenge for equity markets. But I think earnings have a much more direct impact. And that's why we think that's the one you have to pay closest attention to, as there's the greatest risk of a change going forward. Obviously [currency exchange rates] and interest rates filter into earnings as well.

You say there are few positive catalysts for earnings going forward. What sorts of things are you looking for, for that to change?

The biggest issue, in my mind, is the issue of margins. The forecast 10% rise in earnings this year and more importantly the 9% rise next year is dependent on a further expansion in corporate margins to about 10.5% next year, compared to about 10% this year. Margins this year look to me that they should come in somewhat in line with expectations, up from about 9% last year, but 10% is probably the peak in the cycle.

And next year we'll be entering the fourth year of the bull market. It's certainly possible that margins could continue to expand next year. But competitive pressures would dictate that it will be difficult to see further expansion, as is currently forecast. And if we do see some weakness that will in turn potentially hit earnings per share (EPS).

Is the pressure on margins what has fueled the recent M&A activity?

I don't think the M&A story is related to margins. The M&A story is probably more related to excess liquidity in the system and a whole host of factors but it's not related to margins in my mind.

Which sectors do you see as being hardest hit by earnings risk?

Recently we downgraded the materials sector from neutral to underweight, so clearly we see the greatest risk in that highly cyclical sector mainly coming from metals and mining companies as opposed to construction. Also in the capital goods sector we would see some risk if margins do come down. Both sectors are trading at peak margins based on past cycles. So they would certainly be at risk from the margins side. Conversely we're seeing autos and the retail sector at risk from the weakness of the dollar and strength of the euro.

You discuss two quantifiable risk factors: inflation and currency exchange. What do you see as the best way for investors to defend against those?

Our view is certainly that a move into defensives is warranted and that's certainly reflected in our asset allocation recommendations [such as] health care, utilities, consumer staples.

We were also highlighting, from a tactical point of view, telecommunications, given its current status as a more cash-generative, low-growth, high-yielding sector. But since we advocated that view almost six or eight weeks ago the sector has run up quite a bit already and outperformed the market. It may be too late from a purely tactical perspective to increase [investments] there since fundamentally the sector remains unattractive in our minds.

With regard to currency rates, should investors settle in for a long period of strength for the euro against the dollar?

That's certainly our view…. The euro started to appreciate with the dollar when investors felt we were nearing the peak in the U.S. interest rate cycle. And our economists' view for the past 12 months has very much been that once we have a clearer picture of the peak in the U.S. interest rate cycle that would be a key catalyst to see the dollar begin to weaken.

In the first quarter we did appear to have a better idea of the timing and the peak of the U.S. interest rate cycle and the dollar subsequently weakened as a result. However, since then, over the past eight weeks or so, there's clearly been a change in interest-rate expectations in the U.S. and we no longer have a clear idea of when the peak in U.S. rates will occur. Hence the dollar has found some support from that uncertainty. So the timing of a significant decline of the dollar has been pushed back now until we have a better idea of when the Fed will stop raising rates.

In the euro zone, indebtedness has increased to about 56% of gross domestic product (GDP), up about 10% over the last 10 years. Does that make investors extra-vulnerable?

I don't think so myself. That's part of financial deregulation and the widespread availability of savings and investment products. It's resulting in this structural increase from what was, relative to other G7 countries, much lower than Britain and U.S [indebtedness].

So I think it's part of a normal readjustment that at the moment appears to be focused mainly on Britain—where it continues to rise—and France and Italy. Germany is not seeing a substantial rise in indebtedness as a proportion of overall income but the hope is eventually consumers will follow a similar pattern as you have elsewhere in the G7 countries, though it's dependent on the employment outlook, quite clearly. That doesn't seem to bother the French though. They're gearing up anyway.

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