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Stocks to Watch amid Europe's Tricky Dance

Posted
6/25/2010 5:28:00 PM
By: David Sterman
Referenced Stocks:ABB;DEO;GE;MT

During the past few months, experts have been slowly ratcheting down their global economic growth forecasts. A robust first half rebound is likely to be followed by a second half slowdown. Where the global economy heads from there is a crucial question for investors.

It all starts with Europe. The economies of the PIIGS (Portugal, Italy, Ireland, Greece and Spain) are all likely to keep contracting in the second half, as businesses freeze spending and consumers stay at home. In Ireland, for example, the nation's savings rate has soared, which is another way of saying that consumer spending has ground to a halt.

Meanwhile in places like Germany and France, economic activity is hanging tough. A recent economic survey of business confidence in Germany showed impressive gains, no doubt aided by the weaker euro, which is fattening export profits.

Europe's ability to avoid another recession will greatly depend on its trading partners in North America and Asia. Then again, China is counting on Europe to stay in fighting shape to keep sucking in Chinese imports. Here in the United States, our economic outlook is increasingly dependent on our trade partners in Europe and Asia. In effect, we're all hoping and praying that another region doesn't take us down with them.

More than the currency
In theory, a weaker euro should bring a real tailwind to Europe as its exports become more competitive. But currency only plays a small part in reality. Instead, relative competitiveness and a business-friendly environment dictate a country's level of exports. Generally speaking, it is a lot more cost-effective to produce a manufactured good in Germany than in Greece. Germany has the transportation links, supply-chain efficiencies and factory line productivity to outsell its neighbors to the south.

The PIIGS are learning to improve business conditions by making sharp government cuts that should eventually lead to lower taxes. In Spain, labor laws are becoming far more flexible and are encouraging companies to take more chances on payroll expansion.

But there's a real danger that even if Germany and France post slow or moderate economic growth, their neighbors on the periphery of Europe will contract and take the entire European Union down with them. Grumbling from the German or French electorate is likely to only grow louder. The next time you hear rumors that member states may move away from the euro, U.S. stocks will again take a hit. Investors don't like the uncertainty that might create.

Slow progress
The response to the European crisis has not been uniform. The United Kingdom has announced a massive austerity plan that runs the risk of forcing the economy into an even deeper hole as taxes sharply rise and spending is sharply reduced. The PIIGS have no choice but to be similarly austere, inviting those same concerns. France and Germany, on the other hand, are moving in a more restrained fashion. Germany just raised taxes by 11 billion euros, while France has enacted roughly five billion euros worth of tax hikes. France and Germany likely wish they were islands unto themselves right about now. But they know that a divorce from their neighbors would cause more harm than good.

Action to Take --> The current crisis spells real opportunity for companies based in these stronger countries. A weaker currency boosts export prospects and gives them a chance to make a major push into faster-growing markets like Brazil, Turkey and China.

For example, U.K.-based Diageo (NYSE: DEO ) , which makes Captain Morgan, Smirnoff, Johnny Walker and other spirits, notes that export sales are faring well. Shares are roughly -30% lower than before the 2008 economic crisis began and trade for about 13 times projected 2011 profits.

Investors may also want to dig deeper into Luxembourg-based Arcelor Mittal (NYSE: MT ) , the world's largest steel maker. Shares have lost a third of their value on fears of slumping demand, but the company is not seeing much of a slowdown and is well-positioned to capitalize on rising steel demand in Brazil, South Asia and the United States.

You should also check out Swiss-based ABB (NYSE: ABB ) , the General Electric (NYSE: GE ) of Europe. Goldman Sachs points out that shares of ABB start to garner a higher P/E multiple whenever orders exceed shipment (which is known as a book-to-bill ratio greater than 1.0). But it notes that "the multiple has yet to respond."

ABB's sales are expected to moderately decline this year but grow by +6% to +8% next year, simply based on the recently building backlog . If the weaker euro helps boost competitiveness in other parts of the world, then growth will be even more robust.





-- David Sterman
Staff Writer
StreetAuthority

Disclosure: Neither StreetAuthority, LLC nor the David Sterman hold positions in any securities mentioned in this report.

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