Economic growth in the Eurozone (EZ) has now slowed to the lowest levels seen in over a year and the region may be teetering on the brink of its third recession since the global financial crisis. So far this year, investor opinions of a European recovery have fluctuated widely, but the reality of the situation has not changed much. In actuality, Europe remains stuck in a state of stagnation in the midst of a bifurcated global recovery which continues to be characterized by varying degrees of strength from region to region. And while economies that have experienced strong growth and improvements in their labor markets (i.e. the U.S. and U.K.), have also seen inflation expectations recede, falling expectations have been particularly noticeable in Europe.
This article examines which economies around the world could be the most (or least) affected should Europe descend into deflation. The chart below attempts to shed some light on the contagion implications by comparing each country's exposure to the EZ against the current valuation of each country's MSCI equity index. The rationale behind using these two data points is that economic implications and market performance are often not one in the same. So while a country's economy may be adversely affected by a particular event (contagion from the EZ in this case), the subsequent sensitivity of the corresponding equity market's performance will be dependent upon the valuation level at the time the impact occurs.
Data Details and Methodology
The first measure is of each country's economic exposure to the EZ. In this exercise, financial connection is measured by each country's direct and indirect trade relationships with EZ nations. The horizontal axis represents the proportion of a country's EZ trade volume to its trade volume total. Specifically, the measure displayed is the percentile rank of a nation's EZ trade (as a % of total trade), relative to all the countries analyzed in this exercise. This means that a country which ranks higher in terms of percentile (or is plotted further to the right), does a higher percentage of its total trade with the EZ compared to the other countries in this analysis, and therefore has more EZ exposure.
The vertical axis measures how far the current 12-month forward P/E (as of 11/20/2014) is from each country's 10-year average. In order to normalize the measure across all of the nations, and make the comparison between nations as accurate as possible, the distance the current multiple is from its average is measured in number of standard deviations (i.e. the z-score). For example, Russia's current P/E is 4.92 versus its 10-year average P/E of 7.85. In that same period, the standard deviation of Russia's P/E multiple has been 2.71. Therefore, the z-score of the MSCI Russia Index's P/E multiple of is -1.08 [(4.92 - 7.85)/2.71 = -1.08], which can also be stated as being 1.08 standard deviations below its 10-year average. In summation, countries plotted lower on the chart are "cheaper" relative to their own 10-year history and those plotted toward the top of the chart are trading further above their historic average P/E multiple.
Again, the primary purpose of this illustration is to identify the economies which have less exposure to the EZ via trade relations. The countries that are currently at a discount to, or are hovering around, their 10-year average and have below average exposure to the EZ, populate the lower left quadrant of the chart. Some notable observations include:
- Ten countries fall into the "cheap and less exposed" box.
- Only two continents (South America and Asia) are represented.
- Eight out of the ten nations are emerging markets (Japan and Singapore are developed markets).
China Stands Out
Upon reviewing this analysis, China was the country that really stuck out. Given the fact that, 1) China is relatively insulated from a European slowdown, 2) the Bank of China has begun lending to insure the country hits its 7.5% growth target, and 3) the Chinese equity market remains suppressed with valuations at a level considerably (around -1 standard deviations) below the historic average, it seems the prospect of increasing exposure to the area is worth a second look.
This year, investors have been wary to take advantage of China's low valuations which is evident considering the MSCI China index is up only ~2%. This apprehension is legitimate and has mostly been perpetuated by fears of a cooling real estate market and issues within the Chinese financial system. However, it seems those risks are almost fully priced into the equity markets in China and, from the time the market uptrend resumed in mid-October after a month long correction, China has shown relative strength versus other EM nations and may be poised to outperform going into 2015.
Eurozone Woes Have Little Consequence for the U.S.
As seen in the chart, the United States ranks low among nations in terms of EZ exposure. In fact, the EZ has not dragged the U.S. into recession since 1970. However, the Europeans have not fared quite so well when the U.S. falls on hard times. Out of the six U.S. recessions since 1970, four have resulted in a subsequent European downturn. The two times the EZ was able to narrowly avoid being dragged down by their friend across the pond: 1970 and 2001. That aside, it is evident that the cause and effect relationship between these two Western economies has diminished substantially. Over the past three years, the relationship between the two economies, as measured by industrial production, has been insignificant with a correlation coefficient of -0.20.
However, as noted earlier, economic growth and equity market performance can diverge greatly. Although the U.S. is less sensitive than many other nations to any European troubles that may surface down the road, with valuations getting a bit long in the tooth, the risk/return characteristics of U.S. equities become less attractive.
Bottom Line: Global Recovery Will Not Be Derailed by Eurozone Weakness
It is unlikely that weakness in Europe could spark a downward spiral in the global economy. First, the EZ's global footprint has been consistently shrinking over the past decade. In terms of global GDP share, its proportion was down to 14% in 2013 from over 20% at the beginning of the millennium. Yet the primary reason the EZ will not derail the global recovery is the United States, which is maintaining its positive momentum, and should continue expanding at a reasonable pace barring any major policy missteps.
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