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Global economy facing tough test – considerable nervousness in H1 - DAX at 8,000 points – investment strategy: More alpha, less beta

Just a dent in growth, or a bit more than that?
The strong growth the global economy has enjoyed for the past five years is likely to come up against its toughest test to date in 2008. Recession risks, in particular the US economy remain virulent and will be perceived ever more intensely with every item of bad news stemming from the subprime crisis. This will not impact the aggregate global growth data as heavily as in comparable phases in the past because the US accounts for a smaller proportion of global GDP. We expect the global economy to grow by 4.5% p.a. in 2008. However, the slowdown in growth evident in the industrialised nations will diminish markedly. We mere expect a figure of 2% for 2008. If measured in these terms, the rate of growth in most emerging economies is likely to remain strong. However, it will come under strain from the reduced demand for imports in the industrialised nations and rising inflationary pressure. Germany will have to prove it has managed to make the switch from export- and investment-led growth to consumer-led growth.

Higher inflation driven by energy and commodity prices and rising wages, coming at the same time as significant economic risks, are putting the leading central banks in a dilemma. In the final analysis, we assume that macro-economic and financial market risks will dominate the picture in H1 2008, and will prevent a tightening of monetary policy. In the case of the US, there may well be at least one more rate cut in the offing. If and when the economic risks subside, however, a more restrictive policy will probably be an appropriate way to deal with the smouldering inflation risks. However, we feel this is unlikely to be reflected in higher key rates in the Eurozone or the US before the end of next year.

Impervious to the US economy – yes, but …
For quite some time, the shrinking US share of global production nurtured discussions about the idea that other regions were becoming impervious to developments in the US economy. In particular, the emerging economies in Asia are as a matter of fact on a much more stable structural and financial footing than for instance was the case in the late nineties. Europe too appears to be less sensitive to exogenous shocks nowadays.

However, it would be a mistake to believe that the risks of contagion from a weaker US economy are therefore negligibly small. Firstly, there has been a greater convergence of the US and Eurozone/German economic cycles in recent years. In addition, it is necessary to consider knock-on effects that could arise if the growth outlook for further key trading partners – for example in Asia and Latin America – were to be impaired. Moreover the risks are not limited to simple demand-related arithmetic. The global liquidity situation is of key importance to the development of newly industrialising nations in particular. Should the current credit market crunch continue, the flow of capital into the emerging markets could become more modest and therefore slow growth momentum.

Germany: acid test for recovery
Despite a recovering labour market, it is predominantly companies that have benefited from the positive trend in Germany over the last few years. Up to Q3 2007, the proportion of corporate earnings to national income rose, while the labour share of income dropped to all-time lows. We expect this trend to come to an end in 2008. It appears that the effective growth in wages is likely to accelerate further in 2008 because of high capacity utilisation, falling unemployment, which in some areas has even led to labour shortages, and a severe drain on purchasing power, which is chiefly due to the rises in energy and food prices. Our forecast that in 2008 consumption will be the key factor supporting the upturn is based on this underlying assessment. In this context, the greatest risk currently appears to be still-high inflation, which is devaluing nominal increases in income.

Corporate earnings in 2008: Late-cycle phenomena …
Looking ahead to 2008, we believe it will be necessary to get used to the fact that the “golden era” of strong corporate earnings growth is nearing its end. We expect profits of German companies to rise by 6% in 2008, and the EURO STOXX 50 to show earnings growth of 5%. We are thus less optimistic than the market consensus.

In our scenario, the economic growth profile will be flatter and in addition the demand structure in the future will shift away from industrial goods to consumer goods. Late-cycle phenomena, such as higher wage and input costs, will make it difficult for companies to maintain profitability at 2007 levels. The cost advantages of recent years in offshore regions such as Asia and Eastern Europe have decreased noticeably, and given the high capacity utilisation the trend in unit labour costs on the domestic market has already reversed.

After the recent record highs, neither a rapid appreciation of the dollar nor a marked fall in crude or other commodity prices can be expected in the coming year. Companies are therefore likely to see their competitiveness and margins coming under pressure from that side, especially as pricing power vis-à-vis customers will weaken further.

… and structural turning points will weigh on profitability
However, we are reaching turning points from a structural, point of view as well. We believe the period of rapid productivity advances and “easy” restructuring gains – especially for German firms – is over. Next year, high capacity utilisation and a lack of well-trained skilled workers are again likely to mean further increases in wages. In our view, a further structural factor will no longer work in favour of businesses. In recent years, the pressures of globalisation have moved politicians to create business-friendly conditions. Particularly, the German government's reforming zeal is now focusing on a new target group – private households.

Considerable nervousness in the first half of the year
We assume that the demands placed on corporate earnings next year will be permanently raised beyond expectations of pure profit growth. In their valuation equations, investors will accept premiums only for sectors and companies that offer stable, predictable earnings. They will thus be willing to pay for the security provided by quality of forecasts. We expect greater market nervousness especially in the first half of the year, which may well be reflected in higher volatility, until fundamental risk factors have been reassessed in the market. In the wake of this, we expect negative revisions to earnings estimates, above all in cyclical sectors.

Overall, we expect a slightly positive performance from the European equity markets next year, driven by a high dividend yield. In the context of our fundamental expectations, we consider the EURO STOXX 50 would be fairly valued at 4,400 points at the end of 2008. Our target for the DAX is 8,000 points.

Investment strategy: more alpha, less beta
The focus is likely to be on company-specific factors, while global market expectations become less significant. In our investment strategy, we focus on market-independent alpha factors and we look for companies that (1) can maintain their lead in the race for profitability and competitiveness, (2) are less sensitive to macro risks, and (3) can deliver a dividend surprise. We consciously hedge against economic downside risk by taking account of this safety cushion.

WestLB Top Picks for 2008: AXA, BBVA, E.ON, Henkel, K+S, MAN, Porsche, Roche, Swisscom, and United Internet.