UK and Europe Will Muddle Through

06/10/2010 12:01 am EST


Chris Gilchrist

Editor, The IRS Report

Chris Gilchrist, editor of The IRS Report, says the UK and Europe should recover slowly, but their financial sectors remain very fragile, even though the eurozone’s crisis will ultimately be resolved.

Q. How is the UK economy doing right now?

A. We're in a very weak economic recovery from the recession. The [gross domestic product] growth figures have been disappointing, at an annualized rate of under 1%. I don't think that's entirely surprising given the weight the financials have in the UK economy.

The one disappointing feature so far is the slowness of exports to rise as everyone anticipated they would, given that sterling is off 25% against a basket of our trading partners' currencies. While some of the exporters do appear to be doing well, like Rolls-Royce and Weir Group, the overall figures have not risen as much as economists were expecting. So, that's a worry, because we know we have to rebalance from finance back into manufacturing. I think it's probably just a delay given the time [lags from order to delivery] for a lot of the stuff UK manufacturers sell.

We've had the big recovery in the banking stocks, but [they’re still] extraordinarily cheap. What that tells me is that there is a good deal of skepticism about how much toxic stuff is still concealed on the balance sheets.

Q. How much has the UK been hurt by the turmoil in Europe?

A. Not that much. Obviously for most of the biggest companies, Europe is by far the biggest trading partner, the biggest source of revenues outside the UK. But I don't think that's going to be too badly affected by the euro zone’s crisis, given that France and Germany, the biggest economies, are relatively little affected, and British companies weren't exporting a lot to Spain, Greece, or Portugal, for example.

The bigger concern is that if we saw the European banks really getting into trouble, which is the real fear in markets at the moment, then obviously the game changes. We would probably see another fear run coming for the UK banks, which do have some exposure to [southern Europe]—it's just not as big as the French banks and the German banks [have].

Q. But it doesn't sound as if you see that as likely.

A. No, the Europeans have a great knack for waiting until their backs are to the wall and there's virtually blood in the streets, and then they patch things together. It's a coalition of 16 governments—what do you expect? It's very difficult to get them to make decisions. The European Central Bank doesn't have remotely the kind of power, authority, and mandate to do what the Federal Reserve or the Bank of England have done.

Q. Or perhaps the inclination…

A. Or the inclination, because of the Germanic influence on its board, which has been very, very noticeable in the current crisis. But when push comes to shove, I think there will be change. They will fudge it, of course, but they will come up with additional measures that underwrite the banks in such a way that people can be reasonably confident the banks won't go bust. I'm pretty sure that will happen; the alternative, frankly, is so disastrous that we better get the tin hats out.

Q. You've been skeptical for some time on the global recovery. Do you feel vindicated?

A. I've been skeptical about the ability of the emerging markets recovery, which obviously is strong and ongoing, to pull the entire world out of the recession. Quite clearly, Brazil and India and China are doing very nicely, thank you. But obviously that isn't enough to pull the European economies, in particular, out of their recession. The US is a different story, because the administration is far more focused on job creation and is going to take whatever measures are needed to achieve that. We don't have that political will in Europe.

Q. Is that because Europe is prepared to permanently live with higher unemployment?

A. There's no sign of willingness to abandon the social-democratic welfare model that's served Europe pretty well since 1945. Conditions would have to get considerably more difficult before there was any political will for that. Japan's a pretty good model for that: Did the Japanese change their ideas and their culture or their social welfare system, or anything, in the ten years following the crunch in 1990? They didn't.

Q. So, is Europe doomed? Because the perception in the US is that without fundamental reforms the European economy will continue to struggle.

A. That's a very gloomy view. France and Germany are major exporters; they've got competitive manufacturers, world-quality companies in sectors from oil to nuclear power stations and machine building. That's not going to change; these companies are going to continue to succeed on the world markets. It's much more likely that Europe is going to be like Japan from 1990 onwards: very low rates of growth; not a huge amount of inflation; successful businesses going on being successful, but a lot of unsuccessful businesses just meandering along, going nowhere or even going bust.

Q. What's the outlook for UK companies in this environment?

A. It's a very differentiated outlook. Public companies that have access to finance are on the whole doing extremely well. We're seeing upside earnings surprises just as you've seen on Wall Street during the latest earnings season. Earnings this year are going to be ahead of analysts' estimates probably by quite a long way. A lot of these companies do a huge amount of their business overseas and therefore are not hugely impacted by what's going to happen with public spending cuts. But the domestic-focused companies are indeed going to suffer quite badly because of restrictions on public spending.

Q. Which UK market sectors look good?

A. As a good contrarian, you ought to be buying BP (NYSE: BP) shares. It seems extraordinarily unlikely that the share price represents the extent of the economic damage to the company. And if you don't like BP, buy Shell (NYSE: RDS.A), because Shell is also an exceptionally good value on a long-term basis.

Q. Thank you.

Igor Greenwald

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