Earnings set for 2012 slump as recession looms

How many times have you read – or in our case written – that the Eurozone crisis is entering a crucial phase? Well it happened again this week with the focus shifting to Italy, the zone’s fourth largest economy. The idea that the European Financial Stability Fund is too small to bailout the Italians sent yields spiking higher and more shock waves through markets. While the European Union fiddles, Rome may burn, and it’s clear that for a solution to be found, there is more fiddling and burning to come. That is because in its current form, the European central bank is not a central bank in one crucial sense – unlike the Federal Reserve of the Bank of England, it cannot print money to stimulate the economy. Giving the ECB that power requires fiscal integration, which means pushing the squabbling factions of Europe even closer down the federal route.

Given the enormity of this, and the political and ideological opposition to it, it is safe to say that just as Rome – them again – wasn’t built in a day, so fixing the Eurozone may require the ‘lost decade’ that Christine Lagarde, head of the IMF, referred to.

Setting aside this fundamental question of fiscal integration, there is an economy to run, and one that appears to be contracting. And with analysts, economists and fund managers queuing up to predict as recession in the Eurozone and the UK in 2012, then what will the impact be on corporate earnings, one of the few causes for optimism among investors?

Firstly, a Eurozone recession looks increasingly likely. October’s final Market Eurozone manufacturing purchasing managers index , which was published last week and which gauges changes in activity levels across thousands of euro zone manufacturers, fell to 47. 1, revised down from a preliminary reading of 47.3 and down from 48.5 in September.

This marks the third consecutive month the manufacturing PMI has been below the 50 level that divides contraction from growth. Output and new orders indexes plunged to levels not seen since mid-2009.

The survey suggests the crisis is putting a chokehold on euro area business and triggered a move by the ECB to cut interest rates.

The survey's factory output measure plunged to 46.6 in October from 49.6.

"Output, new orders and new export orders all suffered their fastest declines since mid-2009, against a backdrop of weak domestic market conditions, the ongoing debt crisis and a darkening outlook for the global economy," said Rob Dobson, senior economist at Markit.

Broken down by country, in Germany, the economic engine of the euro zone economy, manufacturing activity contracted for the first time in just over two years. Spanish factory activity shrank for a sixth straight month, while conditions in Italy, deteriorated much more sharply than expected to a 28-month low. French manufacturing was also on the back foot in October, with new orders drying up and a fall in output.

Neil Woodford, manager of the Invesco Perpetual High Income fund, which with £11.1bn of assets is the UK’s biggest, said in an interview with Bloomberg that “I do expect the euro zone to be in recession next year and the U.K. economy could well be following suit.”

The freezing of bank lending and wholesale deleveraging in the sector will prevent growth in the economy, according to Azad Zangana, European economist at Schroders, who told Sky's Jeff Randall that the outlook for the region "is negative and politicians have missed their opportunity to prevent a European credit crunch".

The global investment firm warned in its economic outlook report: "Many eurozone banks are already on life support - unable to raise funds in capital markets and heavily reliant on liquidity from the European Central Bank.

The picture around earnings is often conflicting. While a bevy of announcements on Tuesday heavyweights such as Vodafone and Lloyds Banking Group helped the FTSE100 to rally, the longer earnings season goes on, the worse it actually looks. Accrodign to research from Bank of America Merrill Lynch,

Of the 49 companies reporting second quarter earnings so far, 36.7% of companies ‘positively surprised’ and 53.1% ‘negatively surprised’. This says BAML, is well below historical averages of 55.4% and 37.7%. 10.2% of companies have so far reported in-line numbers. By sector, earnings beats are led by Technology (75.0%), Financials (71.4%) and Utilities (50.0%). Earnings misses are led by Discretionary (80.0%), Industrials (71.4%) and Staples (66.7%).

Bank of America’s head of European equity strategy Gary Baker added that earnings growth in Europe will stagnate in 2012 as the US investment bank cut its estimate for profit growth next year to zero from a previous 7%. The consensus among investors is for earnings to expand 10 percent in 2012, the report said.

“We still see downside risk from potential news flow on sovereign-debt issues but recognize that it would take relatively little good news to prompt a sharp rally in markets,” Baker wrote. “A more coherent, detailed and determined policy response in Italy, and by definition Europe, could start to shift the balance in favor of European equities.”

The response by fund managers is that they are focusing on quality companies that will excel in times of volatility. Woodford’s fund is having its best year, largely through adopting a long-term defensive stance. Since 2008, he has been buying stocks like GlaxoSmithKline and British America Tobacco as he positioned the fund for an economic slowdown. While that meant he missed the rebound in stocks geared to growth and the commodities boom of 2009 and 2010, his fund is up 5% this year, making it the U.K.’s best-performing equity income fund. The FTSE All-Share Index is down 8.3% this year.

Companies best placed to ride a recession will be those with exposure to global emerging markets (Gems), which will grow in 2012. According to BAML, Europe accounts for around 57% of sales for European Union companies, with 17% from the US and 26% from Gems. The report added: “A further recovery in Q4 US growth (although we expect deceleration throughout 2012- see margin chart), plus resilient 8%+ growth from China provides a vital offset for Europe in buying time to implement more effective policy remedies. Any slippage in the global growth picture would present a formidable hurdle for Europe in controlling contagion from European peripheral countries in our view. “

The report added: “Although the strength of earnings rebound since the low of the earnings cycle in 2009 has been impressive it is well within the bounds of previous cycles. Based on earnings data going back to the 1970’s a recession now, less than 2 years into a new earnings cycle, would be unusual; but perhaps this would merely confirm that financial crises are very different from ‘normal’ business cycles.”

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