The Case Against German Stocks

The DAX has rallied a huge 2.16% today, as all those worries over nuclear disaster in Japan and chaos in the Middle East were ignored by the market. The index is down a big 4.65% in 2011, and if you think geopolitical risk is the only reason, you’re missing the point.

Margins are getting squished in Europe because of the rising cost of inputs, according Morgan Stanley’s Matthew Garman and team.

Garman says earnings will only grow 12% in 2011, rather than 16% projected by most, because of this margin compression.

From Matthew Garman and team (emphasis ours):

For DM economies the dramatic increase in commodity prices we have seen since early 2009 is likely to provide more of a headwind to margins than in the past, given that they are no longer the marginal source of demand growth. With pricing power weak, the ability of European corporates to pass these costs on to consumers is more challenging. In this environment we think input price pressure will be a key headwind to margins. In Exhibit 29 we look at the difference between the Philadelphia Fed prices paid index and the prices received index, and what this has meant for margins. While input costs are typically positively correlated with margins, when these input costs cannot be passed on, margins have fallen.

The rate at which input costs are being passed on is at a 40-year low. Based on the 12-month average, the gap between the prices paid and prices received indices of the Philadelphia Fed survey indicates that the rate at which input cost increases are being passed on is at its lowest level ever. In Europe we have looked at the gap between CPI and PPI inflation to provide a similar indication of margin squeeze, which again is at an all-time low.

That doesn’t mean all is lost in Europe. Garman’s team reminds that, due to rising energy prices, the energy sector should meet or beat margin expectations.

The Philly Fed graph mentioned, note the sharp decline in prices received less prices paid.

Don’t miss: The impact of the Japanese disaster on the world’s economy >


Photo: Morgan Stanley

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