Continental European equities marginally underperformed global equity returns in 1999 in local curre...
Continental European equities marginally underperformed global equity returns in 1999 in local currency terms but underperformed significantly on a sterling-adjusted basis. Up to 30 November 1999, the FT/S&P World Europe ex UK index was up 18.0% against an 18.8% return for the FT/S&P World index in local currency terms. However, on a sterling basis, the returns were 7.2% versus 21.1% respectively.
The weakness of the euro has been a function of both internal and external factors. The recovery of the Far Eastern markets (particularly Japan) saw international investors switch funds out of Europe to Asia. Public arguments over ECB policy and concerns regarding some countries deteriorating fiscal positions have also served to undermine the currency. Most recently, the suspicion that governments remain unable to resist meddling in corporate affairs, and hence risk holding back much-needed market reforms, knocked the euro back towards dollar parity.
Continental European equities however seem well positioned to continue their more recent period of relative outperformance. On valuation grounds, the market looks less stretched than the US. Whilst it has always traded at a substantial discount to the US, evidence of change at the corporate level suggests that this discount should begin to narrow. (Current discounts of 22% at the P/E level, and 39% at the Price to Cashflow level are near all-time extremes).
The Continental European story for 2000 rests on two levels: cyclical and secular. At the cyclical level, the improving European and global economic recovery, coupled with the weak currency and well-managed inventory cycle, should boost European industrial output significantly. This background, in combination with firmer pricing at the commodity level, should prove attractive for cyclicals (particular the deep cyclicals), as these sectors have the greatest operational gearing, and therefore, earnings leverage.
The secular story in Europe comes from the acknowledgement at the grass-root corporate level that shareholder value is the key to success. There is increasing evidence that European companies are embracing the same philosophy - witness the advent of hostile take-over bids (Olivetti/Telecom Italia, Vodafone/Mannesmann), internal restructuring (Electrolux, Michelin) and the increasing use of stock options to align management interests with that of shareholders (Thomson Multimedia).
Hostile bids are still a comparitive rarity in Europe, and clearly the examples seen thus far have been far from elegant, but the very fact that they are occurring documents that the winds of change are blowing across the European continent. Whether or not Vodafone gains control of Mannesmann, the door to a more market driven deal-making environment has been opened. Criticism has been levelled at the Europeans for focus on the creation of domestic champions rather than cross-border entities. However, strong national players are crucial precursors to cross-border deal-making, and are logical (at least initially) as these deals create the largest and most straightforward synergies.
The object of the recent monetary tightening by the ECB was to dampen above target money supply growth and confirm their anti-inflation credentials. Further rate hikes are likely over the course of next year as economic growth gathers momentum. But the cyclical upturn in Europe should produce earnings growth of 12-15% in 2000, whilst the secular changes that are occurring argue for relative P/E expansion over the longer-term, gradually closing the discount to the US market.
Stephanie Gerrard is fund manager at Aberdeen Asset Management
First mentioned in Cridland Report
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