January 31, 2014 / 2:51 PM / 4 years ago

Euro zone stocks to outshine Britain's FTSE if economy recovers

* Global economy on road to recovery

* Germany, Spain, Italy indexes have big cyclical exposure

* UK’s FTSE laden with defensives, low beta energy stocks

By Tricia Wright

LONDON, Jan 31 (Reuters) - The global economy is on the mend, and for equity investors betting on a recovery through Europe’s share indexes, Germany, Spain and Italy are good plays, while Britain is best avoided in spite of its rude economic health.

Investing by buying an index tracker fund is a popular strategy as it can be cheaper and require less research than selecting a basket of shares.

With the global economy set to grow 3.6 percent this year compared with 2.9 percent in 2013, according to a Reuters poll, and signs that the euro zone is gradually improving, a one-and-a-half year rally in European stocks still has some way to run, analysts say.

Based on recovery prospects alone, Britain looks like a good bet for investors, as it is the most rapidly improving economy in Western Europe.

But, drill deeper, and its blue-chip FTSE 100 share index has a smaller proportion of cyclical stocks, or shares most exposed to the economic cycle, than any other major European index, at just 65 percent, according to Reuters calculations.

In contrast, the German DAX, with a high concentration of auto and chemical stocks, is 81 percent cyclicals.

The DAX hit a record high this month but analysts say solid earnings forecasts for German blue chips means it is still attractive.

Profits in Germany are seen rising 13.2 percent in the next two years, against a 10.2 percent rise over that period for UK-listed companies, according to StarMine’s SmartEstimates - which use the top analysts’ forecasts based on accuracy and timeliness.

“Germany - it outperforms like clockwork when the global economy picks up,” said Peter Sullivan, head of European equity strategy at HSBC, citing it as one of his top picks.

German car parts and tyre maker Continental and automaker Daimler have rallied around 36 percent and 18 percent over the last six months, respectively, against a 13 percent rise in the benchmark, while chemical heavyweights BASF and Bayer have gained 18 percent and 17 percent respectively.

Spain and Italy’s main indexes also offer higher cyclical exposure than Britain, and within that are likely to see extra benefits from their high weightings in financials, analysts say.

As the economy recovers, banks’ bad debt exposure goes down, and real estate markets eventually pick up, also working in the sector’s favour.

“Italy and Spain have come out of recession and will probably deliver the biggest ... (shift) from a very low level of growth to a higher level, and a very significant pick-up in earnings as well,” JPMorgan analyst Emmanuel Cau, said.

“Banks, which are the biggest weight, will be the driver of the upside (in Spain and Italy’s equity markets).”

On Spain’s IBEX, Bankinter and Banco Popular have leapt around 60 percent over the last six months, compared with an 18 percent rise on the benchmark.

Italian banks UBI Banca and BP Emilia jumped around 70 percent and 50 percent over the period, against a 17 percent rise on Milan’s FTSE MIB.

Yet Banco Popular or UBI Banca, for example, are still 75 percent and 50 percent respectively below levels seen before the euro zone crisis erupted in late 2009.

Banks account for 32 percent of the IBEX and 25 percent of the MIB. In contrast, a large chunk of the FTSE 100’s cyclical exposure comes from a 17 percent weighting of low ‘beta’ energy stocks, which stand to gain less when equity markets rise.

Mining shares, whose weakness in 2013 has extended into this year, account for another 8 percent weighting in the FTSE and their low earnings growth prospects have helped cap the overall outlook for UK equities.

SmartEstimate’s projected profit growth of 10.2 percent for UK companies over the next two years is below the average for Developed Europe at 13.6 percent, and far behind Spain and Italy, where earnings are set to grow by more than 20 percent.

That means equity markets in Spain and Italy still look cheap even if valuations for the IBEX and the FTSE MIB have risen to 15.5 times and 13.3 times respectively on a 12-month forward price/earnings basis - against their 10-year averages of 11.7 times and 10.4 times.

France’s CAC index has average earnings growth potential, but it has one of the lowest proportions of cyclical stocks among Europe’s major indexes, at 68 percent.


Equity strategists at UBS, seeking to lift their cyclical exposure, recently downgraded their view on the UK to “small underweight” relative to their benchmark, preferring Japan and continental Europe.

The bank is also “underweight” defensive consumer staples, which account for more than 14 percent of the FTSE 100.

This dwarfs the IBEX’s exposure, at 1.3 percent, as well as the DAX and FTSE MIB at around 5 percent each.

Defensive stocks, whose earnings are reliable because they sell essentials, include Unilever, whose brands include Lipton tea and Dove soap, and drugmaker GlaxoSmithKline.

“We’re certainly more cautious on the UK market compared to other European markets given the make-up of the index - there are greater defensive plays in there compared to European markets,” Barclays strategist Henk Potts, said.

“Better news on growth, a continuation of reforms and accommodative European Central Bank policy should create a stronger earnings growth profile for European companies,” he said.

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