Given the difficulties impacting the euro zone and Europe as whole, results for the fi rst quarter of 2011 were a pleasant surprise. Exceptional items were partly responsible for GDP growth of 0.8% but global economic growth and emerging economies in particular played a major part….
Edmond de Rothschild Group (Market Outlook: 06/06/2011)
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CORPORATE GROWTH RATES AND EUROPEAN GROWTH
Europe is a mature economy with a population that will only grow slightly if at all so economic growth will be limited to the pace seen in recent years (1.5%-2%). European companies depend on domestic growth but their strategy is helping them become more and more independent of their home markets and opening up very different opportunities. Recent results show how remarkably they have overcome the constraints of Europe’s soft growth and the trend will intensify over the coming three to fi ve years.
EUROPEAN GROWTH: SOFT BUT GROWING ALL THE SAME
Since the sovereign debt crisis erupted in December 2010, there has been no shortage of investor concern over the euro zone’s ability to survive the negative impact of troubled peripheral countries. Greece, Ireland and Portugal all ended up seeking aid from other member countries and have agreed to rigorous measures to reduce public defi cits. Investors were naturally worried that this cocktail of a drastic cut in spending and higher taxation would have damaging effects on the rest of the zone.
The latest statistics show that the impact has been more limited than expected. Leading indicators fell, especially the PMI fi gures for May, but remained at levels coherent with average growth levels. Exports saw good growth and made up for persistently lacklustre consumption. Germany played a leading role but the core areas and the north of the euro zone also made a large contribution. France, Austria, Belgium and the Netherlands were just some of the countries to enjoy good growth levels. Non-euro zone countries like Sweden and Switzerland also did well. Investment was dynamic, a signifi cant point as it shows that companies are now feeling confi dent again. There are several reasons behind this upbeat sentiment: the fi nancial sector is back to normal and banks are once again willing to lend, capital markets are providing fi nance and earnings and cash fl ow are at healthy levels. And the outlook for global growth is good.
CORPORATE GROWTH AND THE CONTRIBUTION FROM EMERGING COUNTRIES
European companies have always been involved in the global market place and many have been present in emerging countries since the colonial period. Even if intra European trade always dominated, companies have long been aware of the need to develop exports beyond this zone. The take off in emerging economy growth has had several consequences. For many European companies, emerging countries initially represented cheap sub-contractors. That has now changed. True, the emerging zone is strong on producing goods but its local markets are increasingly being supplied by factories owned by companies in developed countries. Production sites are multiplying and some companies now invest more outside Europe than within.
EUROPEAN COMPANIES: STRONG POINTS
Exports were essential to growth but direct investments in emerging countries are now taking over. The amounts in question are very high. These businesses are starting to make a signifi cant contribution to overall profi tability. This is especially the case for companies which are seeing positive results from their initial investments. Some of these profi ts are reinvested in the emerging zone but they are also repatriated to Europe where they help fi nance research and investment in high value added products.
CAPITAL GOODS AND INFRASTRUCTURE
The global investment cycle was interrupted for two years but has now revived and is running at a strong pace. There are considerable needs in areas stretching from transport and energy to collective equipment. And fi nancing is once again available from a vast array of investors and in the sort of favourable conditions which are helping to sustain the trend. Previously postponed programmes are now back on course. In this huge and very varied universe, Europe has traditionally been very competitive because of the quality and type of industrial material it can offer. In spite of the euro’s appreciation against the dollar, many European exporters have beaten off US rivals. Airbus is just one example. And compared to Japan, foreign exchange markets favour Europe.
CONSUMER GOODS: BRANDS WIN OUT
Another reason for Europe’s success is that European products enjoy a good reputation with the booming middle classes in emerging countries. Brand recognition is crucial and companies have been successful in establishing this. There have been many success stories but some resounding fl ops which should encourage large and medium sized European players to avoid trying to build a presence from scratch. Setting up distribution networks can be tricky and local constraints such as stiff regulations and political aspects can change for the worse without warning. Unilever’s recent problems in China are good example. The group was rapped over the knuckles and fi ned by the government just for talking about raising prices.
The luxury sector is a focal point because it has high growth and high visibility. LVMH’s success in up market products and the way it has developed its distribution network are textbook examples. The company’s strategy has succeeded because of its brand image and policy of setting up in emerging countries. It has also acquired companies. LVMH, Gucci and Richemont are standard bearers for European companies but they are in no way the only companies and not even the largest players as the trend has spread across all sectors.
Europe’s retail distribution companies have also waded into emerging countries but with varying degrees of success. Metro has expanded successfully in central and Eastern Europe, but China has proved more diffi cult to conquer for many foreign chains. Being successful in the consumer goods sector generally takes time. L’Oréal has managed to grow globally but Danone had serious problems in China before sorting out the situation. Being positioned in the high price bracket has often proved effi cient in avoiding local competition from companies which do not enjoy the same brand image. Rémy Cointreau is a good example. Half of its sales are made in Asia in the prestige bracket and China accounts for two-thirds of this.
Other sectors have set up local production sites: BASF (chemicals) and BG (natural gas).
LARGE GROUPS ARE NOT ALONE
Big groups largely predominated for a long time. There were hardly any small or medium-sized companies interested in seeking growth in emerging markets. But today that has all changed: there are fewer trade barriers, logistics have improved, regulatory procedures for setting up a business are now simpler, and emerging markets have grown considerably and are set to enjoy further strong growth. Another contributing factor is that large groups have often helped their SME subcontractors to follow them into emerging markets. At the same time, many sectors have become genuinely global so it vital to occupy the terrain and stop rivals cashing in on such high growth areas. Even if Europe is a large market, staying out of emerging markets would allow rivals to expand and that would ultimately impact companies which prefer to stay put.
There are so many situations and varying contexts that no single strategy would make sense. Moreover, the type of sector, or the level of economic development, imposes particular constraints on a company wishing to break into a specifi c market. When global strategies fi rst appeared, starting from scratch was often the only possibility on an undeveloped market characterised by small local rivals in very disperse sectors. In some cases, companies even created the market. Air Liquide, which has been present in Asia for tens of years, is a good example. But this procedure is drawn out and full of pitfalls; other approaches help reduce the time needed to establish a brand, set up an effi cient marketing tool and build signifi cant market share. The best way to do so is to team up with a well-established local player as Essilor did with Wanxin Optical, acquire a local company as Rexel did in China and India and Legrand did in Turkey or create a partnership with a company in the developed zone which has successfully forged a presence in the emerging zone. Kraft’s acquisition of Cadbury, which is strong in Asia, is a prime example of this approach. Solvay’s acquisition of Rhodia is another example. European companies have been stepping up acquisitions over the last year. These strategies come with their own risks but at least they help avoid socio-cultural blunders and diffi culties with local distribution patterns.
In any case, developing products and services to suit local tastes and constraints is essential. As the contribution of emerging economies to global growth rises, it has never been as vital to “think globally and act locally”. Emerging economies are now a decisive part of the equation in a company’s global strategy. The same conditions for success apply and adapting to market requirements is a key growth factor.
For a long time, emerging countries contributed little or nothing to sales and earnings growth. This was particularly the case for earnings when the investment initially weighed on returns. The situation has changed radically in the last 10 years. Société Générale estimates that emerging countries contributed a little more than 30% to sales growth in European companies in 2002 -about 28% in terms of gross operating profi t- and around 55% in 2010. The same study forecast that within 3-5 years, the contribution to sales growth would be 60% and a little over that fi gure for earnings. Nestlé, which see 45% of its sales coming from emerging countries in 2020, backs up the thesis. Quite rationally, China is the focal point for every global company. Some companies were quick to realise the benefi ts to be gained from a local presence. Volkswagen was a pioneer on the Chinese market and the strategy has made a big contribution to the group’s growth. Some estimates claim that more than half the group’s profi ts come from China. This trend will continue in coming years. For both exports and on-site production, much is at stake in China as the country goes through a vast transformation process. In equipment for electrical grids, for example, ABB has booked more orders from China than the US (13% vs 9%).
Exports to China have already surged but they are expected to triple in the future. Germany is the biggest exporter to China but it still only represents 10% of its total exports. Export growth will continue but the real lever for growth in coming years is to be found in local production sites. As emerging economies develop, consumer goods and services will outpace GDP growth due to improvements in living standards. Investment as a percentage of GDP will naturally decline due to the traditional rebalancing effect. To be able to meet consumers’ requirements and export to neighbouring countries, it is essential to have a local presence to ensure production needs, product design and effi cient distribution channels.
China is, of course, important but the entire emerging country zone needs to be taken into account so diversifying geographical risk is just as relevant. In this respect, the strategy can only work if it is global which means targeting South America as much as Asia, and then Africa at a later stage. Over the short term, the risks are mostly associated with rising energy and food prices and any ensuing central bank response. To varying degrees, central banks are all committed to gradual rate hikes and liquidity tightening. But the second half of 2010 should see less pressure on prices as China’s economy slows down and anticipations become more realistic.
The outlook for European companies has not been as attractive for some time. Domestic markets are seeing modest but solid growth in line with the improving jobs situation. The fi nancial problems of peripheral euro zone countries are counterbalanced by dynamic conditions in those countries which are benefi ting the most from global economic growth. As recent statistics prove, rising exports will continue to drive the economy and productive investment. Some European countries were quick off the mark in understanding the potential in emerging economies.
This puts them in good stead today to optimise returns from major structural changes in the emerging zone. Their presence is entrenched and will be diffi cult to challenge. Other companies are following suit, fully aware that they are some way behind. In return, the entire European economy is benefi ting from good company results in the emerging zone. This dynamic performance at the global level is the best way of guaranteeing stable growth in European earnings.
Disclaimer: The data, comments and analysis in this bulletin refl ect the opinion of the Edmond de Rothschild Group and its affi liates with respect to the markets and their trends, regulation and tax issues, on the basis of its own expertise, economic analysis and information currently known to it. However, they shall not under any circumstances be construed as comprising any sort of undertaking or guarantee whatsoever on the part of the Edmond de Rothschild Group or its affi liates. All potential investors should consult their service provider or advisor and exercise their own judgement on the risks inherent to each fund and its suitability to their own personal and fi nancial circumstances. To this end, investors must acquaint themselves with the simplifi ed prospectus that is provided before any subscription and available at www.edram.fr or from the head offi ce of Edmond de Rothschild Asset Management. Data in this document is not contractual nor has it been certifi ed by the auditors. This document is for information only. Figures refer to previous years. Past performance is not necessarily a guide to future performance.