Having offloaded its short-dated Ukraine bonds to clients (recommending they buy them in size when Yanukovych was ousted for a decent loss so far), the boys from Goldman are up to their old tricks with a lorry-load of German stocks to sell you… “Year to date, the DAX is one of the worst performing indices in Europe (down 4.6% relative to the European market which is flat)… but we think the overall German market will outperform the pan-European STOXX Europe 600 index, and also highlight a list of DAX stocks that are currently Buy rated by our analysts.”
Via Goldman Sachs,
Year to date, the DAX is one of the worst performing indices in Europe (down 4.6% relative to the European market which is flat). A substantial part of this underperformance happened in the last two weeks as political issues surrounding the situation in Crimea and weak data out of China negatively impacted the DAX. In addition the reform agenda in Italy and continued good data from the periphery has likely steered more investors to look at recovery stories there rather than in the core. This underperformance remains modest compared to the strong performance of the second half of last year and we continue to see good upside in the DAX for three main reasons:
1) Earnings exposure to global growth recovery
2) Stronger domestic demand dynamic in Germany
3) Still attractive valuation relative to the European market
Our Global Markets team also initiated today a trade on the DAX index
DAX offers exposure to global growth recovery
We expect the recent weakness in macro data out of the US to prove transitory and growth to pick up from 2Q. In China, while risks to our growth forecast in the near term are to the downside, our economists expect growth to improve from current levels as the year progresses. The DAX offers the highest degree of operating leverage in the European market on our estimates and therefore should benefit from the acceleration in global growth we expect. When measured as the ratio of EBIT growth to sales growth, Germany‘s median degree of operating leverage is 2.5x. This means that for every percentage point of sales growth one can on average expect 2.5 pp of EBIT growth.
In our conversations with clients, we find there are often concerns about German exposure to the weakness in emerging markets. However, when looking at sales exposure data reported by Worldscope, we don’t find the DAX to be substantially more exposed to emerging markets than the broader European market. The table below details the sales exposure of Germany. Of course, sales exposure for the DAX might underestimate the true amount of exposure given the JVs of the autos companies are not included in sales exposure (autos sales are over a third of DAX total sales) and it is likely the EM exposure of the DAX is more specifically China-related.
It however appears that the DAX is really more sensitive to global growth overall rather than just EM growth. This is also true when looking at the recent price action of the DAX: it outperformed the market from June 2013 even as EM underperformed (as measure by our EM exposure basket). At the time, our global leading indicator index (GLI) was in the expansion phase characterized by positive growth and positive acceleration, it has since moved to slowdown (positive growth and negative acceleration). We continue to expect a return into ‘Expansion’ later this year in line with our optimistic outlook for US growth, and therefore anticipate the current slowdown to remain mild.
Currency can also have an impact on the big German exporters and recent comments by ECB President Draghi suggest that the ECB may be becoming more focused on the issue. Draghi said in a speech last Thursday that the level of the exchange rate was “increasingly relevant in our assessment of price stability”. He also said that “any material risk of inflation expectations becoming unanchored will be countered with additional monetary policy measures”. Related to this, Bundesbank head Weidmann also said that “the euro exchange rate is not a policy target for us as monetary policy makers but, of course, the euro enters like other variables in our assessment of the economy”. In that sense, it also affects our projections for inflation and real growth”. These comments ought to be seen as helpful for the export-focused companies. That said, our FX strategists forecast the euro to be roughly flat versus the dollar over the next six to 12 months – and we don’t see the currency as a big support or hindrance to a positive call on the DAX. Indeed over the longer term there has been a slight positive correlation between DAX relative performance and the euro versus dollar exchange rate. A strong euro is often coupled with better European growth and lower risks both of which are supportive of the DAX. Short term though any signs of a weaker euro would most likely boost sentiment for the DAX, provided the trigger was not a risk-off environment.
Stronger domestic demand dynamic; and more resilient EPS revisions
In addition to the higher gearing to an improved global growth dynamic, we also believe that domestic demand in Germany will support the relative performance of the DAX. Our economists expect German real GDP to grow by 2.0% and 2.1% in 2014 and 2015 respectively: this compares to only 0.9% and 1.2% for the Euro area. This better growth is driven by a pick-up in consumption and fixed asset investment. Recent macro data from Germany has been supportive; most recently the January Industrial Production figures released on Friday (March 14) showed continued robust growth. I/B/E/S earnings expectations have also been more resilient for the DAX than for the broader market: since the beginning of the year DAX 2014E earnings have been revised down by 1.9% while the pan-European market has seen revisions of 4.2%.
Still attractive valuation relative to the broader European market
As a result of more resilient earnings and underperformance year to date the DAX, which was already inexpensive relative to the European market, has become even more attractive. On a 12-month forward P/E basis, the DAX currently trades on 11.9x a 13% discount to the 13.7x the STOXX Europe 600 is on. This 13% discount is about a standard deviation away from the historical average.
Sector composition and what we like in Germany
The operating leverage highlighted above is mostly driven by its sector composition: relative to the STOXX Europe 600, the DAX has overweights in autos & parts, chemicals and technology, and underweight in commodities and food & beverages. We favour cyclical sectors (especially those with exposure to developed market recovery) and are underweight basic resources (which the DAX has very little of) as well as relatively expensive defensives (we are underweight food & beverages).
We are underweight chemicals and industrial goods & services (two sectors which are important in the composition of the DAX) but this is somewhat mitigated by two key facts which are not captured by simple sector exposure analysis. First, Bayer which is the largest stock in DAX is classified as a Chemical while the majority of its business is actually pharmaceuticals. Secondly, a large part of the industrial goods and services sector is in the electrical equipment segment on which we are less negative than the EM exposed machinery.
While we think the overall German market will outperform the pan-European STOXX Europe 600 index, we also highlight a list of DAX stocks that are currently Buy rated by our analysts.