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How will the recent Chinese currency moves impact European equities?
We believe there are three main sectors and parts of the European equity market that are impacted by Chinese developments: autos and automotive suppliers; luxury and consumer staples; and energy, mining and the industrial sectors value chain
Niall Gallagher 26 Aug 2015
 
   

We believe there are three main sectors and parts of the European equity market that are impacted by Chinese developments: autos and automotive suppliers; luxury and consumer staples; and energy, mining and the industrial sectors value chain.

 
Before looking at these sectors in detail, first we need to put the FX move into context. Despite the headlines and sharp sell-off in European equity markets, the euro has depreciated significantly versus the renminbi (RMB) over the last four years, even with the recent snap back. I do not believe that a 4–5% depreciation in the RMB set in the context of a 27% appreciation since 2011 will have much of an impact on European export growth, all other things being equal. If there were signs of a hard landing in the Chinese economy or if this was to signal the beginning of a broader RMB depreciation, then there might well be different implications, and this is something that we will monitor – however, for the moment I don’t think much as changed. 
 
Chart 1: EUR / RMB exchange rate
Source: Bloomberg
  
A point often made by economists is that the low level of economic growth experienced in Europe over the last few years has significantly reduced the demand for Chinese exports, and thus GDP growth in China. Hence, the recent pick-up in European economic growth should increase the demand for Chinese goods, and thus GDP growth, so there is a degree of circularity in all of this and some global rebalancing may not be a bad thing. It remains to be seen how this will play out. 
 
Putting that point to one side for a moment, I believe movements in European equities recently have been excessive and indiscriminate, which could be reflective of low August trading volumes and a level of skittishness. The evidence from second-quarter company reporting has been generally positive (with more beats than misses) and the general macro data has also been broadly supportive, particularly for our favourite economies – Ireland and Spain. There are some interesting sector trends and given the recent market moves we think there are some notable opportunities. 
 
Here are some sector thoughts, focusing mainly on issues emanating from China:
 
1. Autos and automotive suppliers: The auto sector is one of the sectors most impacted by China on a fundamental level, and also the sector where there has been the most indiscriminate price action. European car makers – and in particular German car makers – have benefited enormously from China growth over the past five years and the emergence of China as the largest car market in the world. The car makers have limited disclosure on how much of their earnings are derived from China, but it is likely to be in the range of 30–50%, so Chinese trends really do matter. It is clear that there is a slowdown happening in the Chinese car market; whether this is due to a slowing economy or a normalisation from several years of very strong growth is not clear, but there are some very profound implications of this – the principal reason being that German car makers make profit margins in China that are higher than elsewhere in the world. 
 
There are numerous reasons why the Chinese market is so much more profitable, including consumers buying a richer mix of cars (top-of-the-range models, extended wheel bases, high core specification etc) to advantageous transfer pricing between German parent companies and local joint venture partners, as well perhaps as the immaturity of the market. The impact of currency movements on top of this are hard to discern as disclosure is poor, but given the direction of profit during a period when the euro was depreciating against the RMB directionally the impact must be big. Evidence that profit margins in China are coming down (quickly) as the market matures and becomes structurally more competitive will also not help. A decent pick-up in European car demand will help somewhat but unfortunately with European margins half the margin of Chinese ones, profits are set to fall a long way from here.  
 
Our European strategy has no exposure to car makers as we sold all of our positions earlier this year. Our logic for selling was concern that the Chinese market had peaked and pricing would deteriorate, although it was not clear back then, when combined with all-time high valuations, we did not believe the risk / reward to be favourable.
 
Although we sold our positions in the car makers, we kept our positions in the automotive suppliers and it is here that we think the biggest dislocation and indiscriminate price action has occurred in reaction to China macro newsflow. The (stock) market does not seem to recognise that suppliers are volume-driven more than margin-driven; that as long as lower volumes in China are offset by higher production in Europe, overall profitability should be resilient due to higher incremental margins in Europe. Indeed there are reasons to believe they may actually benefit from a shift in demand as European factories are significantly under-utilised, allowing for operational gearing uplifts as European car sales rise. Structurally, automotive suppliers are also exposed to many long-term positive investment themes, such as the need for greater fuel efficiency, safety, autonomous cars and greater penetration of ‘infotainment’. Consequently, we have used the market weakness from Chinese macroeconomic developments to increase positions in the automotive suppliers.
 
2. Luxury and consumer staples: The luxury sector has also been hit hard over the last few days, which we consider unjustified. The slowdown in sales to China has been going on for over two years and is not a new theme. Indeed, in recent second-quarter results there has been evidence of a bottoming in sales and a sequential pick-up in organic growth rates to Chinese nationals (not the same as China sales). 
 
More importantly, it is increasingly clear that there are different segments of the Chinese market, and not all segments have been impacted in the same way by the clampdown on ‘gifting’. It is primarily ‘gifts’ to public officials that have fallen (collapsed), while sales to private consumers have remained robust (particularly those who travel to Europe). We continue to believe that there are strong demographic reasons for continued multi-year growth in luxury demand, although not in a linear fashion as this will remain a cyclical industry. Valuations of luxury stocks have compressed considerably over the last two years, particularly if one adjusts for the net cash held on balance sheets. We have been increasing our positions in this sector in recent weeks. 
 
Our strategy has a limited exposure to consumer staples and no exposure to the traditional food / household & personal care companies that form a large part of the European indices. This is largely based on valuation and a view that there are more attractive combinations of growth, return and valuation elsewhere in the market for us to drive portfolio returns. These stocks have a heavy emerging market sales footprint, so the slowdown in sales across the broad emerging market region has reduced revenue growth over the past two years, but again this is not a new theme. 
 
3. Energy, mining and industrial value chain: We have had a very negative view on the energy and mining sectors for a long time, as well as the industrial stocks that supply in to these sectors. As can be seen below, the oil price has collapsed again following an early summer rally.
 
 
Chart 2: Oil price
Source: Bloomberg
 
 
 
It is very clear that the supply side of the oil industry has not reacted in the way that many predicted with little aggregate supply reduction and rising oil inventories. OECD production (mainly US) remains at record levels and shows little signs of adjusting to the reductions in the oil price. The key reason for this appears to be large scale productivity gains / declining costs in US shale production that have reduced production costs. The nightmare scenario now for the oil industry is that the part of the industry with the greatest supply elasticity (US shale) is also now profitable at lower prices of oil. And in the meantime, Iraq, Iran and Saudi Arabia are also increasing production. The flipside of a lower oil price is a positive cost shock for European consumers and businesses. But for the energy stocks our view remains that the integrated oil shares are not priced for anything remotely like the current oil price, and should the oil price remain where it is or track lower these companies are facing a world of pain.
 
 
 Chart 3: Spot iron ore price
 

 Niall Gallagher is investment director at GAM

 

 

 

 

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