By Bill Blair, head of European research at Scottish Wodows Investment Partnership European equi...
By Bill Blair, head of European research at Scottish Wodows Investment Partnership
European equity investors have welcomed recent signs that the resumption of global economic growth might be just around the corner. After a year in which annual eurozone economic growth slowed from over 2.5% to just under 0.7%, it appears that the onset of recovery may now save the region from recession.
Within Europe itself, capital expenditure has fallen and inventories have been significantly reduced over the last year. This leaves the corporate sector well placed to contribute to a cyclical upturn. Recent business surveys have become increasingly optimistic through- out the region, reflecting confidence in the prospects for an economic rebound. For instance, the German Ifo survey, which is a good leading indicator of Euroland growth, has risen for the last four months.
As a result of this increasingly optimistic economic outlook, cyclical sectors such as paper, car manufacturers and steel have performed particularly strongly recently. While there is still value in some sectors, such as construction, in many cases share price gains have taken cyclicals to a point where valuations are beginning to look stretched at current levels.
A recent sign that the run in cyclical stocks could be coming to an end was caused by a jump in annual inflation in Europe to well above the European Central Bank's (ECB) 2% upper limit. Although this was a result of one-off factors such as the shock to fresh food prices, indirect taxes and rounding up of service prices following the changeover to the euro, consequent fears of rising interest rates may now trigger a move by investors away from cyclical sectors. It is certainly true that global interest rates now appear to have bottomed and Sweden's central bank was recently the first in the current cycle to raise its country's interest rates. It now seems only a matter of time (probably in the summer) before the US Federal Reserve raises rates and when the Fed moves, central banks around the world generally follow.
This will leave investors looking for sectors that are not negatively affected by rising interest rates. The pharmaceuticals sector is one area that is likely to appear attractive, particularly those stocks that are not currently subject to patent concerns. Technology, media and telecoms stocks benefited from the upturn in investor sentiment towards the end of last year, but despite further declines this year, it is still very difficult to find value within these sectors.
Certain software stocks, such as SAP, have performed well because of their strong market position, although IT Hardware stocks generally remain over-valued.
While it is true that interest rates are near the bottom of their current cycle, the European Central Bank should be restrained when it comes to tightening monetary policy this year. The sharp slowdown in growth over the past year has created an output gap, leaving room for growth to recover this year without fuelling inflation.
This favourable monetary stance, in conjunction with an upswing in the domestic economy, should allow European growth to exceed its trend rate in 2003.
European equity investors will still have to search hard to find value but the overall outlook for the European economy and, therefore, equity markets is certainly becoming more positive.
German Ifo survey risen over last four months.
Cyclical sectors outperforming.
Upswing in domestic economic cycle.
ECB must be prudent when tightening rates.
IT hardware stocks remain over-valued.
Jump in annual inflation.
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