Slowing U.K. Growth Could Hit ADRs

By Mark Whistler | August 07, 2008 AAA

Gross domestic product growth from advanced economies is suffering, there's just no way around it. The most recent proof comes from the International Monetary Fund's downgraded U.K. growth forecasts. Specifically, the IMF lowered UK 2008 GDP growth expectations to 1.4% from 1.8% for 2008 and to 1.1% from 1.7% in 2009.

Adjustments to forecasts are to be expected, but these definitely caught my eye. There are a pair of American Depository Receipts (ADRs) that could be particularly vulnerable to a slowing British economy. (For background reading, check out What Is The International Monetary Fund? and The Importance Of Inflation And GDP.)

Bigger Problems Ahead
All of Europe is facing an inflationary debacle, something that likely won't ease until the U.S. dollar recovers some lost ground over the past six years. Looking in the U.K. specific issues, inflation is presently at 3.8% year over year, something simply not acceptable by the Bank of England (BOE). The issue is that with inflation running at highs, the BOE will have a hard time lowering rates in the months to come, something needed to stimulate liquidity (and GDP growth) in the U.K.

On Thursday, the BOE kept interest rates on hold at 5%. Inflation is high in the U.K., but "second round effects" - inflation that trickles into wages - remains low, that's why there was little chance of a rate hike today. The IMF specifically said, "And while there is scant evidence of second-round effects, as wages remain subdued, indicators of long-run inflation expectations have risen further."

The final piece of the puzzle will be lack of growth in savings, whereby the IMF concedes public net debt as a portion of GDP could breach the protocol 40% ceiling. Overall, the UK is in for some tough times in quarters to come, something that could hurt earnings of ADRs focused on the overseas economy. (To begin with the ADR basics, check out What Are Depositary Receipts?)

ADRs to Watch
While none of the following companies are directly exposed solely to the U.K. economy alone, at the end of the day, if the pound loses value, so could earnings based on exchange rates alone.

Pearson Follows Time Warner's Lead
Pearson PLC (NYSE:PSO) is an international provider of media content including Financial Times Group, Westminster Press and Pearson Professional. The question will be whether the company will be able to sustain the GDP firestorm that could take place in the U.K. over the next six quarters. At present, fundamentals are quite reasonable, as seen in the P/E of just over 14. However, the stock is presently down about 10% for the year.

Taking notes from Time Warner (NYSE:TWX), in the midst's of the U.S. economic debacle, the stock has fallen about 35% from the January 2007 high. Interestingly, Pearson's high came in May of 2007 (the stock is down about 26.4% since), indicating the U.K. competitor may be a laggard of the U.S. media conglomerate just mentioned. Overall, Pearson's may find some more downside as investors infer trouble in the UK, but at around $10 a share, the stock could certainly be a well priced, if no major issues surface.

Vodafone Vulnerable to British Belt Tightening
Vodafone Group PLC
(NYSE:VOD) could also be in for a few hiccups, even though the company is a global leader in cellular and telecom products. Vodafone is a massive company and therefore could be well insulated from the U.K.'s upcoming economic issues; however, with 17,411 subscribers in the U.K., revenue could be lost as consumer spending falls through the floor. The good news is that Vodafone has subsidiaries in Asia, Africa, Australia, the U.S. South America and larger Europe. It's in the process of inking a deal in India, too.

For the year, the stock is down just over 25%, indicating that investors have already begun discounting the stock. Like Pearson though, if the flailing UK economy creates further selling, a buy opportunity would likely surface in the quarters to come. (To learn more about international investing, read Investing Beyond Your Borders.)

Bottom Line
Some advanced economies are seeing lower than expected growth. Inflationary pressures, interest rates, and a lagging U.S. economy all contribute to the IMF's forecasts for the United Kingdom. While GDP forecasts are always subject to large revisions, the most recent changes are certainly eye opening for those investing in the U.K.

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