In the past four years European equity markets have generated fantastic returns. The impact of the e...
In the past four years European equity markets have generated fantastic returns. The impact of the euro in prompting greater competition for capital has helped to produce significant restructuring at the industry and corporate level, and even governments have adopted more equity-friendly policies.
The growth of an equity culture has brought many new, faster-growth companies to market. Demand for equity investment by both institutional and retail investors has risen rapidly. Technology has also had a profound impact on equity returns.
All of this has raised the return on capital employed (ROCE) in quoted companies and hence the value of the equity in these businesses. We have come a long way: European equities are up 130% since the beginning of 1996, so is there any potential left in European equity markets?
In the near term there are two negative pressures on the market. First, the economic growth surprise is over. It is becoming apparent that European economies are moving past the peak point of acceleration in this cycle. Industrial production is growing by over 5% year on year and it seems certain that it will slow. Earnings in most cyclical industries are at or near their peak - paper companies don't make 25% ROCE for long.
Second, rising interest rates. The ECB is raising interest rates to levels we last saw in 1995. Along with the aggressive movements by the US Federal Reserve this is likely to slow growth and put the valuation of equities under pressure.
These dual pressures are likely to see the volatility of the market continue over the coming months. However, we believe that the prospects for European equities are still good and that there is potential for a rally in the fourth quarter of this year. All the positive trends that have benefited the market in recent years are intact and three key factors will aid this.
First, bond markets will start to discount the peak in interest rates. While inflation has risen it remains under control and bond markets look solid. Financial stocks which went through their own bear market last year will benefit, including BNP, Banca Intesa and asset gatherers such as Skandia.
Second, liquidity will become positive again. The scale of new issue activity has overwhelmed the market in recent months, but it looks set to become less hectic. We believe liquidity flows will pick up towards the end of the year in their usual seasonal pattern. We see the potential for returns in stocks such as Nokia, Ericsson and ASM Lithography where earnings will continue to surprise.
Last, the euro will produce positive earnings revision. On a trade weighted basis the euro is as competitive now as it was in the mid-1980s. Despite slowing economic growth the euro will help to sustain earnings growth.
Neil Robson is head of European equities at Baring Asset Management
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