Opportunity Knocks When Markets Are Rocked
Strength in German shares drove a powerful performance in the first half, but in July and August, investor profit-taking has laid siege to European equities. The reason? U.S. subprime mortgage delinquencies have led to widening corporate credit spreads at home and abroad. And since the ultimate magnitude of U.S. subprime exposure on the books of European banks has yet to be determined, we think this is only making the credit crunch worse.
As risk is re-priced in Europe and around the world, investors are worried that a higher cost of capital may slow future European profit growth. In addition, private equity leveraged buyout activity, long a driver of much-needed restructuring for European corporations, has slowed as demand for lower quality bonds has dwindled.
Standard & Poor's Equity Research, however, believes the sell-off in European equities only signals a correction, and not a new bear market. Though the cost of capital is on the rise everywhere, it remains low by historic standards, and we don't expect it to trigger a recession in Europe or force a peak in corporate earnings growth.
S&P expects Eurozone GDP growth of 2.5% for 2007 and 2.4% for 2008 - nowhere near recessionary levels. For the United Kingdom, we forecast 2.6% growth for this year and 2.3% growth for next. In addition, analysts continue to expect earnings growth for S&P Europe 350 companies both in 2007 (+8%) and 2008 (+9%).
In terms of valuations, European equities are among the cheapest in the world. In late August, the S&P Europe 350 index was trading at only 12.8 times estimated 2007 earnings vs. 15.5 times earnings for the S&P 500, and 18.3 times earnings for the Japanese S&P Topix 150 index.
On the merger front, wider global credit spreads are slowing the flow of private equity deals. However, this shouldn't affect Europe too much, since corporate buyers dominate most of the mergers & acquisition (M&A) activity there.
Through July 13, 2007, 84% of the $1.2 billion of total year-to-date European M&A was corporate, according to data from Capital IQ (a division of Standard & Poor's). With European corporate balance sheets still relatively underleveraged, we expect corporate M&A to continue, albeit at a less frenzied pace.
For these reasons, we maintain our positive outlook on Western European and U.K. equities, and recommend long-term investors use current weakness as an opportunity to add to their European equity holdings. We do expect wider global credit spreads to increase equity volatility over the near-term.
S&P's global asset allocation includes a 17% weighting to developed international markets. Europe and the United Kingdom make up about half of this allocation. Investors seeking concentrated European equity exposure might consider the iShares S&P Europe 350 Index ETF (IEV), which tracks the eponymous index. Alternatively, for those seeking broader exposure to developed overseas stock markets, the MSCI EAFE Index ETF (EFA) is composed of developed overseas markets including Germany, the United Kingdom, France, Switzerland, Australia, New Zealand, Singapore, and Hong Kong.
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