Still constructive on Europe, but risks from China/EM are serious
We remain constructive on the Eurozone outlook, despite the recent downgrade in our GDP forecasts to 1.4% for 2015 and 1.9% for 2016. However, downside risks need to be taken seriously, above all a hard landing in China and broader EM turbulence.
Fallout from China could affect the rest of the world through three channels:
- Trade linkages. Europe’s trade exposure to China is moderate: Exports from the EU (the Eurozone) to China account for only 3.1% of EU exports (Eurozone: 3.3%), equivalent to 1.0% of GDP (Eurozone: 1.1%). However, there is substantial variation within the EU, with Germany having by far the highest share of exports to China (5.8%) and as a share of GDP (2.1%). Next in line are Finland, France, the UK and Italy, with export shares of 2.5-4.5%. Our preliminary conclusion would be that, based on trade linkages to China alone, the economic damage to Europe should be limited and manageable, despite Germany’s elevated China exposure. Yet this conclusion might be premature.
- Financial linkages. Closer financial linkages exist between China and a number of countries in Asia, above all some of the Asian financial centres. For Europe, however, financial/banking sector linkages seem less relevant.
- Sentiment linkages. A hard landing in China would likely have negative sentiment effects worldwide –definitely on financial markets (as we see right now), probably on corporate confidence, and in some places on consumer sentiment. There would be few places unaffected by severe problems in China– although the degree of fallout would vary by region, country and sector
1pp loss in Chinese (EM) growth to cut EU growth by 0.1-0.3pp (0.2-0.4pp)
We estimate that a 1pp slowdown in Chinese growth would reduce EU growth by c.0.1-0.3pp, which should be manageable, although the impact on Germany would be higher. However, the more likely scenario might be a broader EM slowdown, which would affect Europe with a higher sensitivity of 0.2-0.4 pp.
The damage could be even greater if a slowdown in the US and other developed markets had to be factored in. Importantly, some of the negative impact in Europe would likely be offset by the positive effect of lower commodity prices and more accommodative monetary policy.
What are European Equities pricing in?
We work backwards from current levels of the market to estimate what is being priced in. Given how depressed earnings are (after no earnings growth for close to 5 yrs) we believe investors need to look to cyclically adjusted measures of valuations.
We look at two: the cyclically adjusted P/E and the P/E on trend earnings. Both suggest the market is pricing in a c.20% fall in earnings estimates. The macro backdrop which might cause this would be a mild recession in Europe in 2016, a sharp fall in US growth and close to a 4ppt further downgrade to China and EM growth. We think this is too pessimistic.