Can Europe avoid the worst of the global slowdown?

Richard Pease, manager of the New Star European Growth Fund: The decoupling argument - that other countries were no longer reliant on the US economy for economic growth - always had a hollow ring to it. With the dollar still the pre-eminent trading currency and the US accounting for more than 25% of the global economy, America's problems were bound to affect other nations.

While emerging market economies were lauded for their fast growth, too few commentators looked at the role of speculative money and foreign investment. US investors tend to retrench during a time of crisis and in recent months those dollars that flowed to emerging markets reversed direction. At the same time, nervous US traders and hedge fund managers have unwound their carry trades, either voluntarily or forcibly to meet redemptions, once again switching into dollars from other currencies.

Europe was a more plausible candidate for decoupling. With its developed yet diverse economies, it is less reliant on external capital and the high per capita incomes of Europe's people result in significant trade within the region. Some 70% of European Union (EU) trade in goods and 60% of EU trade in services is between EU countries. For a while EU growth was ahead of US growth and it seemed possible that Europe could avoid the US slowdown. In the second quarter of 2008, however, the eurozone economy as a whole contracted.

Spain and the UK, two economies that like the US have had house price booms that have turned to busts, escaped economic decline in the second quarter but as the chart below shows early indications suggest this was a near miss. Figures just released show the UK economy contracting 0.5% in the third quarter. By contrast, Germany and France contracted in the second quarter although this was after rapid growth in the first quarter. As ever, one statistic in isolation should be treated with care.

In digging deeper, it can be argued that some eurozone countries are better positioned to cope with the downturn because of the relative financial health of their domestic consumers. In Germany, renting a house is considered as normal and desirable as owning a home; less than half of German households are owner-occupiers. While areas of Germany have experienced significant rises in house prices, the country as a whole has not been through the decade-long property boom that has taken place in other countries. Most of Germany's growth has been built on manufacturing, not increased consumer indebtedness built on the unstable foundations of inflated house prices.

While the UK has to contend with a painful reverse of its house price boom, the main issue for the German economy is whether its exports will hold up. German consumers may be less indebted than their US and UK counterparts but Germany's big current account surplus means it may be more exposed to a slowdown in global trade. In other words, the country could suffer because its manufacturers are so efficient; having built such impressive export operations they may now face declining sales in a world of falling demand.

In such circumstances, investors need to be selective, focusing on companies with quality products and services and benefiting from strong long-term demand trends. Among German companies, the New Star European Growth Fund holds Wincor Nixdorf, the leading cash machine manufacturer, and K+S, which is benefiting from strong demand for its fertiliser ingredients. Elsewhere in the Europe excluding the UK region, the fund seeks companies with earnings resilience, such as Kone, the Finnish lift manufacturer, which also has a large service business that provides recurrent cash flow.

Europe's manufacturers are likely to benefit from the recent fall in commodity prices. Most European countries are net importers of resources so the rapid decline in the prices of oil and metals is welcome. The Russians and Brazilians are less happy. Since Europe tends to specialise in advanced manufacturing rather than primary extraction, the falling input prices will go some way to improving manufacturing margins and relieving the downward pressure on revenues that comes from lower sales volumes. Even Europe's energy companies may benefit as a large proportion of their profits are related to downstream refining and marketing rather than exploration and production. The fund is overweight in energy producers through holdings in diversified oil majors such as Total and ENI, which, despite the recent fall in oil prices, have traded broadly in line with the rest of the market.

In contrast, the fund has significantly below-average holdings in bank shares. At the end of 2007, it was decided to cut its bank holdings in response to the developing credit crunch. This move proved to be justified, with the sector under considerable pressure throughout 2008. The Lehman Brothers insolvency in September appeared to crystallise many problems and shook confidence in the industry. Events turned so sour that governments were forced to take radical action to prevent a systemic meltdown.

At first, the European response was dismal, with an each-country-for-itself mentality taking hold despite EU institutions. Ireland agreed to unlimited deposit protection for savers only to fall foul of the EU Competition Commission because the protection did not initially include foreign-owned banks operating in Ireland. Germany felt press-ganged into doing something similar while the UK discussed raising the level of protection. This piecemeal approach had the opposite effect to that desired as it highlighted the lack of direction. Equity market falls seemed to jolt political activity, however, and on 8 October, in a co-ordinated move, the US Federal Reserve, the Bank of England, the European Central Bank (ECB) and the central banks of Canada, Switzerland, Sweden and the United Arab Emirates all cut their interest rates by half a percentage point. The ECB's move was surprising since it had been hawkish earlier in 2008, raising its repo rate because eurozone inflation remained above its target. The cut in interest rates should help to reduce financing costs in the eurozone and also take some pressure off exporters, for whom the strong euro was an added hurdle in winning sales overseas.

The fund has made considerable changes to its country weightings. Ireland has been suffering from its exposure to the property and financial downturn. As a result, the fund has gradually reduced its Irish holdings, with the result that by 30 September the country weighting was just 2.06% against more than 8% a year earlier. The fund ended September with no holdings in Spain. This is because the sharp fall in construction activity in Spain is likely to lead to a contraction of its economy, with wider implications for earnings in other sectors.

Overall, the fund's positioning has become more defensive. At 30 September, food and drug retailers comprised 7.09% of the assets, while the fund had big positions in two pharmaceuticals, Actelion of Switzerland and Merck of Germany. It has, however, been careful not to overpay for defensive stocks. For example, E.ON, the German power utility, might be viewed as defensive yet its shares fell 18.09% on a total return basis over the first nine months of this year as volatile energy prices weighed on the share price. The preference has been for companies that ought to maintain or even grow their revenues during a downturn. Examples include Sodexo, the contract catering and facilities management business, which is highly cash-generative. It is seeking to expand earnings by winning more contracts for schools, hospitals and prisons, where its size brings purchasing power advantages. Similarly, Fielmann, the German spectacles retailer, is one of a handful of retailers that tend not to be sensitive to economic conditions. The chart below shows the divergent performance of these companies.

The Europe excluding the UK region cannot insulate itself from the effects of global economic downturn but its diversity means it need not follow wholesale the direction of the US. Nevertheless, the region's equity markets have not escaped the global increase in risk aversion among investors and the share prices of many companies have fallen despite their clear merits.

As the fog begins to clear, however, investors should begin to focus their buying attention on companies that have the depth of management, the clarity of strategy and the balance sheet strength to trade through the current difficulties. In focusing on such companies, the fund is seeking to avoid the worst of the market weakness while being invested in the types of companies that should participate in any upturn when sentiment recovers.