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For Winning Bets in Europe, Look to China -- Update

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02/17/2017 | 07:35pm CET
By Riva Gold 

Europe's economy is gaining strength, but its rallying stock markets may say as much about momentum in China.

Shares of European companies with the tightest links to the Chinese economy have significantly outperformed their peers, helping the MSCI Europe index, a basket of stocks based in 15 European countries, rise more than 20% from its bottom in February 2016.

European stocks most closely correlated to the Chinese economy -- such as mining companies and producers of capital goods like machinery and equipment -- have fared 30% better than the overall market over the past year, according to an analysis by Deutsche Bank. Sectors with the most negative correlation to China -- including telecoms, retail and pharmaceuticals -- have performed the worst.

For decades European markets have followed Wall Street's lead, but China is becoming an increasingly big influence on the direction of local markets.

"It's been the year of the China trade," said Wolf von Rotberg, a strategist at Deutsche Bank.

To be sure, local shares have also benefited from improvements in both the European and U.S. economies.

The eurozone economy kept pace with that of the U.S. for the first time since 2008 last year while its jobless rate fell to a seven-year low.

The economy is expected to grow 1.6% this year, according to the European Commission, and a majority of fund managers surveyed by Bank of America expect European economic growth and inflation to pick up over the next year.

That has helped renew appetite for the region's equities despite concerns over the potential destabilizing effects of upcoming elections in France and the Netherlands.

But large parts of local stock markets are climbing higher on China's back.

European publicly traded companies collectively generate only 5%-6% of their revenue directly from mainland China, according to data provider FactSet. But China exerts a much bigger influence, through its massive impact on the global economic cycle, commodity prices, and broader appetite for risky assets.

That link was made clear in early 2016, when a meltdown in Chinese stocks and concerns about a falling yuan hit European shares hard. The Stoxx Europe 600 fell roughly 17% in the first six weeks of the trading year amid worries that the world's second-largest economy was on the brink of a downturn -- more than twice the declines it posted in the immediate aftermath of Britain's vote to leave the European Union.

But China's economy appeared to stabilize after officials pumped it with cheap credit and state spending, pushing growth to 6.7% in 2016. China's producer-price index hit a five-year high in January 2017 after several slack years, while China's manufacturing sector has posted growth for six straight months. This has supported demand for European machinery and lifted economically sensitive parts of the region's stock market with it, analysts say.

Sectors such as German industrials have done particularly well over the past year as a result of China's stimulus program, said Paul Markham, a director at Newton Investment Management.

"Europe is more of an economic follower," he said, requiring growth from areas such as China and the U.S. to drive its economy and stock markets higher.

Europe's mining sector, the region's best performer over the past year, has also been lifted by sharp gains in metals prices spurred by expectations for Chinese demand. Copper futures are up about 30% from a year ago and iron-ore futures have climbed to multiyear highs.

China accounts for more than half of global demand for most metals, according to S&P Global Ratings.

The U.K.'s FTSE 350 Mining index jumped 145% from its bottom a year ago, compared with a 32% rise in the broader FTSE 100.

Companies with big direct revenue exposure to mainland China have also outperformed. Luxury-goods maker LVMH Moët Hennessy Louis Vuitton, for instance, recently pointed to China as one reason its net profit jumped 14% in the second half of 2016. Its shares are up 31% from a year ago.

But because Europe is following China's lead on the way up, it is also exposed to downside should the country's growth waver.

While few expect a hard landing soon, recent data, including industrial profits and steel production, have suggested China's manufacturing sector may be cooling quicker than expected following last year's record stimulus. Analysts also point to a slowdown of new credit issuance relative to gross domestic product.

That isn't to say Europe isn't highly reliant on domestic and U.S. drivers as well.

Europe's beleaguered banking sector has also been a big driver of the recovery in European bourses, with lenders in the region up around 34% from a year ago, though the gains may have more to do with expectations for higher U.S. interest rates and a stabilization of Italian banks than with China.

But even among European banks, China exerts influence. Shares of Standard Chartered, which derives roughly 43% of revenue from the Asia-Pacific region, nearly doubled in the last year while HSBC shares rose 68%. That compares with a 32% increase for Deutsche Bank shares and 21% for UBS, two banks with significantly smaller Asian revenue exposure.

"It's been a quiet one...but the Chinese effect has had more of an impact [on European stocks] than Trump," said Caroline Vincent, investment director at Cavendish Asset Management, referring to the boost Donald Trump's presidential election gave to many markets.

Write to Riva Gold at riva.gold@wsj.com

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