Silvia Quandt & Cie. AG, Merchant & Investment Banking: 2010 mid-year review

Silvia Quandt & Cie. AG, Merchant & Investment Banking: 2010 mid-year review

Silvia Quandt & Cie. AG, Merchant & Investment Banking / Sonstiges

01.07.2010 10:48

Veröffentlichung einer Corporate News, übermittelt durch die DGAP - ein Unternehmen der EquityStory AG. Für den Inhalt der Mitteilung ist der Emittent / Herausgeber verantwortlich.

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Silvia Quandt Research GmbH Bernhard Eschweiler [e-mail] [phone] www.silviaquandt.de

Strong momentum versus uncertainty

Estimates for German growth in 2010 are being revised up. The latest example is the Kiel Institute for World Economics (IfW), which raised its 2010 growth forecast from 1.2% to 2.1%. At the same time, markets and economists are getting more concerned about 2011, fearing that fiscal tightening in most OECD countries will stall growth. The IfW, for example, cut its German growth forecast for 2011 from 1.8% to 1.2%.

The Silvia Quandt view was from the beginning of the year that the German recovery would gather momentum in 2010. If at all, the forecast has to be slightly trimmed (from 2.6% to 2.4%) because the rebound was delayed by one quarter. For 2011, Silvia Quandt forecasts continued solid growth. The impact of fiscal tightening should be less than feared and partly offset by very accommodative monetary conditions, stronger corporate and labor market fundamentals as well as ongoing strong growth in emerging markets.

The economic outlook bodes well for a favorable market environment. Short-term interest rates will stay close to zero and long-term government bond yields are likely to fall further. The Euro will be soft, especially versus emerging market currencies. Earnings estimates have been revised up, but with the consensus outlook getting more pessimistic the potential for upside surprises increases. Against this background and very low bond yields German stocks are cheap. The missing link is confidence, which is not helped by the ongoing uncertainties surrounding the Euro. Still, positive growth and earnings news will help the market. Exporters and companies with overseas activities are a clear buy. Yet, consumer stocks may surprise more given the expected pick-up in domestic demand. Financial stocks still face problems, but insurance companies, especially re-insurers, should show strong operational performance.

Second-quarter surge to show more legs

The upward revisions of 2010 consensus growth forecasts for Germany have more to do with putting together the facts than vision. After a sluggish performance around the turn of the year, industrial production (IP) surged going into spring. In April, IP was already 3.7% above the first quarter average. Moreover, the simultaneous surge in orders (orders lead production by two months) suggests that IP rose 5% in the second quarter as a whole. Even if all other sectors of the economy stayed flat, which is unlikely, this would imply real GDP growth of 1.5% (6% annualized) between the first quarter and the second.

The size of the second quarter surge is unlikely to be repeated, but it probably has more legs than widely expected. Inventories, which had been rebuilt in the second half of 2009, are running low again. Furthermore, some sectors, most notably car producers, face order backlogs and are having to run extra shifts to catch up with demand. Thus, third-quarter growth is unlikely to show negative payback for the second-quarter surge, but will probably extend the positive momentum.

Better fundamentals for 2011

The bigger question, however, is what will happen going into 2011? Silvia Quandt believes that concerns over the impact of fiscal tightening are overdone.

- First, while the government's overall consolidation program for the next four years seems large, the measures for the first year (2011) are small, worth less than 0.5% of GDP, and may not get fully implemented. - Second, the ECB will stay accommodative while fiscal policy in Europe is tightening (especially outside of Germany) and inflation remains absent. Interest rate hikes are unlikely over the forecast horizon. If at all, the ECB will cut rates to make its intentions clear and venture further into quantitative easing. - Third, the corporate sector has recovered exceptionally well from the crisis, with profits climbing back to pre-recession levels. Combined with rising sales, this bodes well for new investments and hiring. In a recent survey, 86% and 80% of companies reported that they would hold or increase investment and employment respectively. - Fourth, labor market fundamentals have improved much faster. The economic recovery clearly sparked the labor market turnaround. However, corporates' willingness to hire also demonstrates their confidence in growth as well as their own health. Germans are not big spenders, but rising employment will undoubtedly help consumption. - Fifth, prospects for exports are likely to remain favorable in 2011. True, fiscal austerity will clip demand from the rest of Europe and, to some extent, other OECD countries. On the other hand, growth prospects in emerging markets are set to stay bright. If at all, the problems there will be too much rather than too little. Policymakers are starting to pull the brakes, but very gently as they increasingly recognize that they cannot rely on OECD countries for future growth (see China). Germany is well positioned to benefit from this scenario, especially if the Euro stays soft, which seems most likely.

Putting it all together, the Silvia Quandt forecast calls for 2.1% growth in 2011. This is a tad lower than the 2.4% growth estimate for 2010, but well above consensus forecasts, which are currently around 1.6% and likely to move lower. The main drivers of growth are expected to be investment (0.8% growth contribution), private consumption (0.6% growth contribution) and trade (0.5% growth contribution).

Low bond yields and a soft Euro

The economic and policy outlook is positive for the market environment. The combination of fiscal consolidation and

accommodative monetary policy means that long-term government bond yields will be well supported. For banks, the carry game is still one of the best ways to generate low-risk income, which will be needed to restore balance sheet health. Ten-year German government bond yields, for example, are expected to dip below 2% over the forecast horizon.

Fiscal tightening and easy monetary conditions also mean a softer currency. The Euro has limited downside versus the Dollar from current levels since the US is likely to run a similar policy mix. Negative political news concerning Europe could lead to a temporary move toward parity. Otherwise, the trading range is likely to be between 1.15 to 1.30 USD/EUR. On a trade-weighted basis, however, the Euro is likely to trade softer, especially since China restarted its liberalization policy, which should lead to a broader strengthening of emerging markets' currencies.

More good news for equities

Better than expected economic growth, low interest rates and a soft Euro bode well for equities. At the start of the year, we argued that corporate earnings would be stronger. At that time, DAX 2010 EPS consensus estimates stood at 455 points, up 29% year-on-year. Still, consensus forecasts underestimated the earnings momentum. DAX 2010 EPS estimates stand now at 598 points. Hence, while the DAX remained almost unchanged for the year, earnings estimates rose by 31%. Not only had the analysts underestimated the growth potential. In a recent survey by the Handelsblatt, 60% of corporate leaders replied that the first half of 2010 developed better than anticipated. The better performance of aggregate earnings also reflects the fact that the DAX is less geared towards the financial sector than other major European indices. The market cap of financials is about two thirds of that of industrials in the DAX, while it is more than four times in the UK.

Earnings momentum to lead to more trust

The positive 2010 earnings figures result from a higher-than-expected 2009 base, strong order intake in Q4 2009, which turned into sales and profits in Q1/Q2 2010 and continuous improvements in competitiveness as well as product and market strategies. Germany produces goods, which are in global demand. The car industry is a good example of the combination of branding and cost efficient production. This mix allows the industry to perform successfully against the competition in fast growing economies.

These developments not only secure 2010 earnings estimates, but will also improve trust in 2011 estimates, currently at 680 DAX points. High earnings momentum and increasing confidence in turn should lead to higher valuations. The DAX trades at just 10.3 times 2010 earnings and 9 times 2011profits - reflecting an implicit untypically high risk premium investors take into consideration when investing in equities. In stark contrast, bond investors appear to expect record low risk in sovereign bonds, with Bunds trading at a bond market P/E (inverse yield) of 38.5 times. This mismatch is largely the result of equity investors capitulating in 2009: insurers paired equity holdings, trustees cut equity exposure and individual investors favoured passive investment strategies, if any at all.

The Silvia Quandt view of further downside for bond yields implies earnings yield ratios (EYR) of 26% for 2010 and 23.4% for 2011. This stands against a long-term average of more than 60%. The high risk aversion appears to be unsustainable. However, critics of the EYR model highlight that current interest rates are a result of monetary actions (i.e. central banks purchase programs) rather than market preferences.

Comparing equity market valuations with BBB bond yields would be more appropriate, as both instruments are fed by the same corporate profitability. Interest payments, however, are paid out of EBIT. EPS or dividends reflect net earnings profitability. The latter could rise significantly, while interests on bonds remain unchanged. In any case, both investment vehicles should yield almost the same: current BBB bond spreads are 548 bps over 5- year bond rates of 1,75%, suggesting a P/E of 13.8 times, or 10.4 times after-tax earnings. This would lead to a DAX level of 6,625 (trailing 12 months earnings) or 7,275 on 2011 earnings. Performance potential for broader indices (HDAX) is similar, for the MDAX slightly lower.

These estimates are based on today's risk aversion, which appears to be elevated and should decline in the coming quarters. The upcoming regulatory changes initiated by the G20 nations (>90% of global GDP) would, we believe, provide more transparency in the financial sphere, which leads to less uncertainty. Initial effects are expected in lower BBB bond spreads, followed by increasing appetite for equities.

Sector performance to vary

- In financials, banks might recover from their weak performance. G20 indications suggest less capital requirements than feared, while stock exchanges should benefit from more 'traffic' onto their derivative platforms. Insurers should continue to focus on operational excellence, with re-insurers potentially in a better position than direct insurers. The real estate sector might benefit most from an opening of a securitisation market. The latter might be a 'side-effect' from more transparency. - German exporters should continue to perform well. The Euro exchange rate seems to develop into an additional 'stimulus package'. This appears not to be

fully priced in today's markets. Automobiles and industrial stocks outperformed the DAX by a threefold, while chemicals underperformed.

- Consumer related stocks already reflected the better than anticipated employment scenario in Germany and outperformed the DAX, despite widespread fears of declining consumer demand and higher savings. With employers more likely to hire than fire, the fear will disappear. German Christmas sales might be good: consumer/retail stocks typically achieve 4/5 of their annual profits in the final quarter. - Utilities in Germany underperformed the broader indices significantly since the Lehman debacle. Lately, they were target for potential additional tax and fee burden. Also, they are involved in the weaker CEE countries. All this, however, is unlikely to justify a 20% discount to current DAX valuation and an 18% under-performance year-to-date. - Technology and software stocks outperformed the DAX, similar to industrial shares. However, this does not include renewable energy stocks, which carry a high weight in the TECDAX and pulled this index lower. Despite the rise, renewables appear to be still attractive, benefiting also from renewed M&A activities.

What can go wrong?

While earnings levels are stable, earnings momentum is set to weaken. If there were already a reflection of the earnings momentum in current share prices, we would worry. The overall macro-economic picture also suggests a stabilisation of current growth estimates.

A source of concern, however, remains on the political side: The G20 nations need to find a common ground of understanding in terms of regulation, control and cooperation. Key risks for the German economy are newly emerging trade barriers. Some points of concern might be found in the G20 statement, which request a more 'balanced' economic development in China and Germany. As mentioned before, German exports are a function of demand - mainly in those countries, which request a more balanced growth (the US wants to double exports in the future to boost employment).

A further uncertainty lies in governments' needs for new income sources, i.e. higher taxation. If introduced just in Germany, it would create risks to P/E based valuations and could impair dividend payments (as indicated by the German utilities on the back of the so-called 'nuke fuel tax'). Given current valuations, it seems that these concerns are more than fully priced in.

Aside of these 'eco-political' risks, uncertainty might re-emerge, if the current coalitions finds it impossible to continue with its work. A political vacuum in the latter half of the year would - we believe - impair investment sentiment.

Next triggers

The DAX outperformed major European indices. We expect this trend to continue in the 2nd half of the year, but with a lower margin. The main reason is that the financial sector should recover some of its losses in the next months. This sector is more significant in indices outside of Germany. Trigger could be the partial repayment of state funds, both in Germany (Aareal bank started already) and in Europe.

German stocks should benefit from the Q2/H1 2010 reporting season, which should quantify the positive surveys of the IFO and ZEW institutes. Companies might lift their 2010 guidance at that time, giving investors more comfort to re-invest funds into equities. Asset based sectors might be in the focus of this investor segment. First indications of such moves might emerge after the summer break and ahead of the November G20 financial summit.

Note: the macro view was written by Bernhard Eschweiler, senior economic advisor, and the equity strategy was written by Ralph Groenemeyer, head of research.

Disclaimer

This analysis was prepared by Bernhard Eschweiler, Senior Economic Advisor, and Ralf Groenemeyer, Head of Research , and was first published 1. July 2010, Silvia Quandt Research GmbH, Grüneburgweg 18, 60322 Frankfurt is responsible for its preparation. German Regulatory Authority: Bundesanstalt für Finanzdienstleistungsaufsicht (BaFin), Graurheindorfer Str. 108, 53117 Bonn and Lurgiallee 12, 60439 Frankfurt.

Company disclosures

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01.07.2010 10:48 Ad-hoc-Meldungen, Finanznachrichten und Pressemitteilungen übermittelt durch die DGAP. Medienarchiv unter www.dgap-medientreff.de und www.dgap.de

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AXC0077 2010-07-01/10:48