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Possible Mild Recession In Europe But Markets Overreacted
Malaysia Perspective | 04 October 2011

By Yeoh Mei Kei

August 2011 was a month that was full with negative news to the equity markets. First, we have the downgrade of the US credit rating by Standard & Poor, and then followed by the deterioration of the European debt crisis. European Central Bank (ECB) data shows that an unnamed bank tapped the ECB 7-day emergency liquidity facility for the first time since February 2011 to borrow EUR 500 million as short-term working capital. This incident has caused a plunge in European equity markets where banking stocks were being sold-off.

Credit crunch and liquidity risk may have reoccurred in the European banking system as banks will generally only borrow from central bank (which charges higher borrowing cost) when they have difficulty getting funds from the open market. This can be interpreted by European banks unwillingness to lend among themselves currently as they are worried that the other banks might hold a large amount of PIIGS’s sovereign debt and suffer huge losses. Under such circumstances, European banks would prefer to keep their capital safely in ECB rather than lend it out. Furthermore, liquidity in the European money market has started to dry up as the European debt crisis has intensified and caused the withdrawal of money market funds from Europe. With banks reluctant to lend and liquidity dries up, the lending activities in the Eurozone have declined quite dramatically recently.

Reluctantance to Lend Will Worsen the Economic Growth in Europe
Investors fear the credit crunch as it caused the previous economic recession. During the 2008 financial crisis, banks suffered substantial losses due to toxic assets, and the increase in bad debt reduced banks’ lending ability. Now, the fear of counterparty risk and the issues of PIIGS’s sovereign debt have again reduced the willingness of European banks to grant loans to businesses. Small and medium companies will always be the first to suffer during a credit crunch as they are unable to obtain funding from banks. This could lead the small and medium companies to file for bankruptcy. Unemployment could increase by then, which in turn will hamper the economy growth in Europe. In the worst case scenario, we believe that recession in the European economy may be inevitable.

Possible Short-Lived Mild Recession in Europe
Under the situation whereby European countries substantially reduce their government spending, we expect the economic growth in Europe during the period between 3Q 2011 and 2Q 2012 to contract by 1% and thereafter return to the normal growth level. The main reason why we believe that Europe will fall into recession is that European countries are now actively pursuing fiscal austerity measures, and such measures could undermine business confidence and consumer spending.

The current situation in Europe is different from US recession in 2008. in which the US economy was overheated with excessive credit growth. Companies in Europe have been de-leveraging since the beginning stage of recovery and credit growth now has been relatively slow. This indicates that the current financial situation for corporate in Europe is healthier as compared to 2008, and companies now has better ability to ride out the challenge of an economic slowdown. As such, we expect the recession in Europe will be short-lived and will not be as severe as the recession in US during 2008.

Corporate Earnings Revised Downward for Slower Economic Growth
Over the long term, earnings growth dictates the returns of the equity market. Previously, we utilise consensus earnings forecasts as a basis for our own estimates. As our economic outlook now differs from the consensus view, this requires some changes to our previous forecasts. We now expect a mild recession in the Europe and slower-than-expected growth in the US, which has negative implications for corporate earnings. We have correspondingly lowered earnings estimates for equity markets under our coverage, attempting to factor in slower anticipated economic growth. Corporate earnings will likely see some negative impact in 2012 as growth stalls in Europe, but we expect the slowdown to be short-lived and thus forecast a stronger recovery in earnings for 2013 (the stronger percentage increase relative to consensus estimates reflects the low base of our 2012 estimates).

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Most equity markets have experienced a strong correction, but we doubt that the steep downward movement in prices is justified given that valuations were already modest prior to the recent decline. Prices tend to be suppressed when expectations and sentiment are weak, and we expect that investors who can see past the current turmoil will be able to reap substantial rewards when prices become more reflective of the value of the underlying companies in the future.

* Yeoh Mei Kei is a Research Analyst at

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