Sovereign debt has dropped a couple of notches down the agenda since the start of the third quarter, but to forget about the problems of Europe’s largest public deficits completely could be a mistake.
The turning point in market sentiment came when Europe’s banks passed their stress tests with flying colours. By implication, this suggested they could withstand the pressure any economic troubles might put them under in the near future.
While I do not doubt the results of the tests, I remain cautious that certain banks in Europe, in particular those with large direct exposure to the most troubled European economies, could still face challenges that become too strong for them to overcome quickly.
This is a good example of how macro conditions can impact a business, but evidence suggests investors have a habit of spending more time than necessary forecasting economic growth. This is because stock market performance is not necessarily correlated to economic growth but instead to dividend growth.
If this is so, in most cases, the most important place to focus attention is on a company’s dividends and its ability to grow them, rather than the prevailing economic conditions. This is because the dividend is a clear illustration of a company’s ability to generate cash and return it to investors.
A dividend’s growth rate is an extension of that illustration. The second point is that in a global economy, economic forecasts become less relevant.
At a national level they are too narrow; on a global scale too broad. The Swiss economy has little impact on the fortunes of Nestle, for example, and predictions that cover world GDP prospects hide too much detail to make sense.
Through this financial crisis, companies have focused on repairing their balance sheets rather than offering short-term rewards to shareholders, but many of the companies that have done this successfully and are capable of growing their dividends in the future remain attractive.
So, rather than becoming preoccupied with the likelihood of the European (or any other) economy slipping back into recession, investors should be looking for companies with exposure to growing markets that are attractively valued. Europe has these in abundance.
Sam Morse is the manager of the Fidelity European fund
