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September 2011
The European economy has been recovering, but southern Europe remains weak and recent trends in Germany have been less encouraging. The summer saw sharp declines in equity markets and concerns about sovereign funding in Greece.
Valuations are compelling, corporate earnings growth is robust, balance sheets are strong, profitability solid and cash flows are excellent. Which means companies can sustain both growth and generous shareholder returns, but forecasts have been revised down sharply as austerity measures and delays to payments to Greece from the bail-out fund weighs heavily on confidence.
Recent events have confirmed that the sovereign crisis is a work in progress. France and Germany have struggled to agree terms for the Greek bail-out and austerity is unpopular and puts pressure on politicians to force through change. There are available funds to bail-out Greece, Ireland and Portugal. The constraint has been public opinion and whether members of the eurozone are willing to concede economic sovereignty. The eurozone is an incomplete system. The financial crisis has exposed this and the political response to the crisis has at times appeared dysfunctional and not helped by what has resembled a game of chicken on a grand scale.
Compared to three months ago, the global economic picture has weakened, with signs of weaker ISM numbers from the USA and PMI data in Europe. Calls for extending the size of the European bail-out fund, the EFSF, and the creation of a European bond designed to replace existing country bonds have been rejected by the German coalition government.
In the meantime, markets have had a growing concern about the solidity of European banks in the face of a potential Greek default and a possible recessionary impact on bad loans.
At a company level, businesses continue to grind on, with few real signs of a major change to the economic environment to justify the slump in the market. However, memories of the financial crisis of 2008 are quite fresh and the problems surfacing in funding government debt in Greece, Italy and Spain, may yet prove unbearable without significant and dramatic intervention by the ECB.
The Investment case
Valuations are compelling, corporate earnings growth is positive, balance sheets are strong, profitability solid and cash flows are excellent.
The enlargement of the eurozone provides a pool of labour and a counterweight to an ageing population.
Companies have a strong presence in international markets and will continue to prosper from further globalisation and growth in emerging markets.
The ECB has some room to lower rates and to reverse its recent gradual tightening policy.
Europe is a consensus underweight.
The future of the European Union, and the Euro have become very uncertain, because it is not clear which way politicians will proceed. If the Greek problem can be solved it would be positive, but if it is not then disruption to all of the European economy is likely and the path to recovery will be interrupted.
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