Shared currency but no shared outlook

Richard Pease, manager of the New Star European Growth Fund, gives an update on Europe: Much of Europe may share a single currency but the individual countries and companies it contains face unequal challenges and prospects. Investors need to recognise this by being selective.

In September, a fire in the channel tunnel meant that Britain's land link was briefly severed once more with the continent. For a while it seemed a fitting metaphor for the region's separate economic fortunes. Britain was doomed to slide into recession, sunk by its over-reliance on finance and an inflated housing market, while the less reckless continental Europeans would be somewhat insulated from the worst of the downturn.

The economic data of the last few weeks tell an altogether different story. Italy and Germany posted a fall in their gross domestic product in the third quarter of this year, following on from a contraction in the second quarter. Statisticians seized on these two consecutive declines to proclaim both countries to be in recession. The UK, on the other hand, escaped this ignominy by the narrowest of margins through having recorded flat growth in the second quarter. It will require a fall in gross domestic product in the fourth quarter before the recession, which arguably began at Easter, is officially recognised in the UK.

Yet Germany and the UK face recession for very different reasons. The UK is a smaller, although some might claim amplified, version of events in the US. The UK is facing an extended period of austerity and de-leveraging as it pays the price for excessive lending by banks to overstretched consumers.

For Germany, which scarcely participated in the great housing bubble by default of the majority of its households being renters rather than owner-occupiers, the blame for the recession appears to genuinely lie abroad. Yet Germany is facing a problem not too dissimilar to that of China. Both countries are very efficient manufacturers and both depend on their export markets. The downturn in the global economy, however, leaves them struggling to find buyers for all their output. Already, in Germany, workers are being put on downtime as manufacturers seek to prevent a build up of inventory.

It could be argued that Germany potentially exports too much and imports too little. To that end, changes in exchange rates can have a useful balancing effect. Some 70% of European Union (EU) trade in goods and 60% of EU trade in services is between EU partner countries. The collapse in the value of the pound against the euro will go some small way in helping to rebalance the economies of both the UK and Germany. The UK needs to export more and consume less, Germany needs to encourage its domestic consumers to consume more.

Less clear cut is what the stronger euro means for Italy. The country is facing its fourth recession this decade. The straitjacket of the euro means that Italy lacks the opportunity for a currency devaluation that might have restored its competitiveness. The goodwill amongst European bureaucrats is perhaps too strong to lead to a breakdown of the euro project but Italy's woes demand longer-term reforms that the country may be unwilling to make such as engaging in the wage discipline that the Germans endured earlier this decade to promote competitiveness.

Nor, for that matter, may the Germans be prepared to repeat this exercise in wage restraint. German unions have been more vocal in pushing for higher wages, citing the eurozone's recent high inflation rate. Moreover, when banking fat cats are rightly or wrongly being blamed for the world's economic ills, the unions have all the ammunition they need to press for the general workforce to get a greater share of the pie. Until, that is, unemployment rises. In Germany, the unemployment rate is still falling but this tends to be a lagging indicator so the union's moment in the sun is likely to be brief. This is clear from the Ifo index of business sentiment, which is traditionally a herald of economic direction. As the chart below shows, the near term looks challenging.

Fortunately, the outlook for the eurozone is not entirely dismal. The European Central Bank has moved away from its hawkish stance and has cut interest rates in response to falling stock markets and easing inflationary expectations. A falling oil price should also be a big boon to a region that is a net importer of oil and gas. With the region being less indebted than its Anglo-Saxon counterparts, it is possible that the eurozone could start to see some benefits from lower interest rates, lower energy costs and a less competitive US dollar. In fact, France even defied the odds last quarter to record a pick-up in consumer spending.

Looking at a European country's broad economy and making sweeping generalisations is, therefore, too simplistic. Within each economy there will be a multitude of different companies dancing to a different beat and even at the corporate level it is important to discern between companies trading in the same or similar sectors. In this regard risk-averse investors appear to have shunned many companies that fundamentally are well positioned.

Good examples are Europe's lift manufacturers, Kone of Finland and Schindler of Switzerland. They are being valued as industrials yet health and safety regulations are responsible for a considerable proportion of their profits. Every lift installed needs official maintenance and safety checks. Much as Rolls-Royce in the UK makes money from maintaining its installed jet engines, so these companies business model benefits from the recurrent earnings provided by maintenance contracts. Companies such as these have been indiscriminately sold-off in the market downturn, their classification as industrials belying the strength of their services businesses.

The same is true of Wolters Kluwer, the Dutch publishing group. The company is classed as a media stock yet the majority of its sales are to professionals, who depend on its publications to function or keep abreast of their sector. Core subscription products make up 70% of the company's revenues. It sales are less consumer discretionary and more consumer staple.

The good news is that the market volatility has created some genuine buying opportunities. Those investors who focus on quality companies and seek to understand what is driving the economic outlook and the overall market for that company stand to generate considerable gains when investor sentiment recovers.