European Stocks Hooked on Emerging Markets Stretch Values
For the first time ever, European companies are relying on emerging markets for a third of all revenue, stretching equity valuations as Chinese growth slows and protests turn violent from Turkey to Brazil.
Led by Swatch (UHR) Group AG and SABMiller Plc (SAB), Europe will get 33 percent of sales from developing nations in 2013, almost three times as much as in 1997, according to data compiled by Morgan Stanley and Bloomberg. While U.S. enterprises make 70 percent of their revenue at home, businesses in Europe, mired in the longest recession on record, are forecast to obtain less than 50 percent from their own economies this year.
Even though stock-market bulls say dependence on faster-growing emerging markets will boost long-term profit expansion, bears are focused on more immediate challenges. The Stoxx Europe 600 Index trades at 12.6 times estimated earnings, 11 percent more expensive than the average of the past three years, data compiled by Bloomberg show. China’s economy, which grew at an average rate of 9.2 percent from 2009 through last year, is projected to expand 7.7 percent this year, the least since 1999.
“An economic slowdown in emerging markets will definitely have an impact on the revenues of European companies,” William de Vijlder, who oversees about $650 billion as chief investment officer at BNP Paribas Investment Partners in Brussels, said in a June 27 telephone interview. “We are seeing weakness in the macro data. Our view is that there will be more negative surprises than positive ones from emerging markets now.”
The Stoxx 600 gained 1.7 percent last week, trimming its first monthly loss in more than a year. The gauge has retreated 8.2 percent from an almost five-year high on May 22 after China money-market rates reached a record and the Federal Reserve said it may pare bond buying should the U.S. economy improve. The index rose 1.2 percent to 288.29 at the close of trading today.
Shares of European companies most reliant on emerging markets have led the rally since equities bottomed in March 2009. The Stoxx 600 Personal and Household Goods Index, which includes luxury-product producers such as Swatch and Cie. Financiere Richemont SA, surged 155 percent, while the broader market advanced 80 percent. A measure of food and beverage shares, featuring SABMiller and Vevey, Switzerland-based Nestle SA (NESN), climbed 138 percent.
Swatch generated 37 percent of its sales from China last year, while Geneva-based Richemont got 41 percent from Asian countries excluding Japan, according to data compiled by Bloomberg. London-based SABMiller, the world’s second-largest brewer, receives more than 80 percent of revenue from outside Europe and North America. Nestle, the biggest food maker, got about 15 percent from Brazil, China and Mexico.
The rally has pushed the Stoxx gauge of personal-goods companies to 16.3 times estimated earnings, 29 percent more than the wider market, data compiled by Bloomberg show. The Stoxx 600 Food & Beverage Index trades at 17.7 times projected profit, a 40 percent premium, data compiled by Bloomberg show.
“Certain proxies for emerging-markets growth, like the personal and household goods sector and the food and beverages sector, are now pricing at significant premiums,” John Bilton, European investment strategist at Bank of America Corp.’s Merrill Lynch unit in London, said in an interview on June 17. “It’s not to say it’s the wrong theme in the long run, but you’re paying a lot of money to access it right now.”
Since the beginning of the year, analysts have cut their projections for combined 2013 earnings at Stoxx 600 companies by 6.6 percent to 22.57 euros a share, estimates compiled by Bloomberg show. While that’s an increase of 58 percent from last year, it’s still down from the 2007 peak of 27.45 euros.
Slowing growth in China, the world’s largest emerging economy, may put a brake on revenue at European companies. The nation’s imports unexpectedly fell in May and industrial output also trailed economists’ projections. China’s seven-day repurchase rate reached an all-time high of 12.45 percent on June 20, more than triple this year’s average of 3.82 percent, fueling concern a cash squeeze may worsen the slowdown.
China’s economy will expand by 7.7 percent in 2013 and 7.6 percent next year, according to economists’ projections compiled by Bloomberg. India’s gross domestic product will increase 5.1 percent, matching last year’s rate that was the slowest since at least 2004, the data show. Brazil is estimated to grow 2.5 percent after a 0.9 percent advance in 2012.
The World Bank cut its total growth forecast for developing nations to 5.1 percent last month, from 5.5 percent in January.
Brazil is witnessing its biggest street protests in two decades, a movement that began as complaints against higher bus fares, while Turkey’s government is facing the largest demonstrations in 10 years. Social unrest is making it difficult for luxury-goods makers to encourage shoppers to spend, Ermenegildo Zegna, chief executive officer of Trivero, Italy-based Ermenegildo Zegna Group, said in an interview in Milan on June 22.
Even as European exporters face short-term hurdles, CEOs need to reduce their reliance with the euro-area economy in a seventh straight quarter of contraction, according to Raiffeisen Capital Management’s Herbert Perus. Emerging markets offer the fastest-growing demand and diversification will pay off over time, he said.
The European Central Bank forecasts the 17-member euro-zone economy will contract by 0.6 percent this year. Revenue within developed European markets will fall to 46 percent of all sales, according to the Morgan Stanley study of 505 companies. That’s down from 51 percent in 2012 and 71 percent in 1997, when the New York-based bank began collecting data. Sales to emerging economies were 12 percent that year.
“World growth will still come out of emerging markets, if not at the momentum we saw for the last 10 years,” Perus, who helps oversee about $36 billion as head of equities at Raiffeisen in Vienna, said in a phone interview on June 27. “Consumers in emerging markets try to live like Europeans or Americans in the long term, therefore they will still buy European products. It’s still a very good idea for companies to focus on that market.”
At the beginning of 2013, brokerages from Goldman Sachs Group Inc. to Credit Suisse Group AG had recommended buying European stocks with sales in emerging markets to benefit from growth outside the euro region.
Goldman Sachs strategists led by Peter Oppenheimer ended their bullish call on June 20 and instead recommended short positions, without identifying specific stocks to bet against. Weaker prospects for emerging markets make shares of European companies that rely on them more vulnerable to losses, Oppenheimer wrote.
In a short sale, speculators borrow securities to sell them on the expectation they will be able to buy them back at a cheaper price before returning the loan.
Credit Suisse cut its recommendation on food producers to underweight in May, meaning investors should hold fewer of the shares than are represented in benchmark indexes. It maintained an overweight rating on European luxury-goods stocks.
European shares may be overvalued given the outlook for emerging economies, according to Peter Sullivan, head of European and U.S. equity strategy at HSBC Holdings Plc.
“Investors are used to looking through soft patches in growth, but the longer they last the greater the risk that confidence will ebb away before growth re-accelerates,” Sullivan wrote in a June 19 report after the London-based bank cut its economic outlook for China. “The key issue for investors is whether this weakness is priced in. In Europe, we believe it is not.”
SABMiller is trading at 18.4 times estimated earnings, a 46 percent premium to the Stoxx 600, according to data compiled by Bloomberg. That compares with an average premium of 14 percent over the past four years.
Shares of Richemont (CFR), the world’s second-biggest luxury-goods producer, trade at 17 times projected income. That’s 35 percent more than the Stoxx 600, compared with the 21 percent average premium since 2009. Richemont has jumped to 83.55 Swiss francs, more than five times its price in March 2009.
Swatch, the biggest maker of Swiss watches, has more than quadrupled since its January 2009 low. The shares are 25 percent more expensive than the broader index, Bloomberg data show.
In addition to luxury-goods and food companies, the oil and gas industry will get 54 percent of revenue from emerging economies this year, according to Morgan Stanley.
Subsea 7 SA (SUBC), a London-based provider of oilfield services, plunged the most in 4 1/2 years on June 27 after cutting its earnings outlook on higher-than-estimated losses from its Guara-Lula project off the Brazilian coast. Milan-based Saipem SpA, Italy’s largest oil and gas engineer, on June 17 reduced its forecast for 2013 earnings by as much as 750 million euros ($975 million), citing rising costs for projects in Algeria.
For Stewart Richardson at RMG Wealth Management LLP in London, the slower pace of expansion in emerging economies compounds the problems European companies are facing at home.
“The whole China slowdown story, and by extension, the emerging markets story, is an issue for investors of European stocks,” said Richardson, who oversees about $100 million as chief investment officer at RMG. “When your home markets are going through a recession, any headwinds in the global markets make it more difficult.”
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