With good prospects for the US economy and European equity valuations remaining modest, the current rally in stock markets should develop into a more durable uptrend
It is fashionable in the UK to be critical of many aspects of macroeconomic management in Continental Europe. Growth in the eurozone economies has slowed to a crawl, probably less than 1% this year, against an estimated 1.6% in the UK and more than 2% in the US.
Forecasts for 2003 and beyond also imply a pedestrian outlook. The ECB is unfavourably compared with the Fed for its lack of credibility and its slowness in countering economic weakness, while politicians are increasingly regarded as ineffective and unhelpful to business.
Not surprisingly, European equities are viewed in a similar light, as sclerotic and dull and deserving of a discount for their supposed unexciting prospects. This is especially the case among retail investors, for whom the asset class was very much the flavour of the month at the time of the global stock market peak in 2000. In other words, expectations are exceptionally low. This is a promising starting point.
But to get things into proportion, we need to take a walk down memory lane. The 1990s was an outstanding decade for Continental European equities, with the sector consistently outpacing returns from the more mature UK stock market. Exciting developments were afoot.
Bond yields fell significantly as public sector finances were reformed in preparation for the advent of economic and monetary union in 1999. The corporate sector and capital markets became more closely integrated. Companies discovered shareholder value, accelerated their restructuring programmes and increasingly adopted Anglo-Saxon standards of disclosure and communication with investors and analysts. The result was a significant upward rerating of European shares.
Years of strong performance attracted retail savers into equities (many for the first time) and governments took advantage of this newfound appetite to launch a host of privatisation issues into an enthusiastic marketplace. The year 2000 saw the peak of this trend, with expectations hopelessly distorted by the technology boom and scant regard being paid to share valuations or the inherent risks of buying equities after such a long bull market. Sadly, steadily rising share prices turned into an irrational boom, which was quickly followed by a damaging bust.
Current investor attitudes are a world away from the 1990s. Europe has suffered disproportionately during the global bear equity market of the past two years and the mood of extreme optimism has been replaced by one of deep pessimism and widespread scepticism.
In Europe, as elsewhere, there has been an enormous divergence between the relatively healthy returns achieved by defensive areas, like beverages, food and tobacco, and the severe losses suffered by holders of formerly highly-valued growth sectors, especially technology and telecoms.
This position has been accentuated for millions of private investors by the fate of many of the formerly popular privatisation issues, most notably by Deutsche Telecom and France Telecom, which lost some 90% of their value when measured from peak to trough.
A measure of how far the wheel of fortune has turned can be most aptly illustrated by the short life of the Neuer Markt. Launched in 1997 as a means of raising capital for fast-growing, mainly high-tech companies, it peaked in March 2000, thereafter plunging to earth and being condemned to death in the autumn of 2002. But, perversely, the timing of the Neuer Markt's demise could be viewed in a very positive light by contrarians.
As befits former enthusiasts, investors have become too dismissive of the driving forces that motivated European equity markets. They have confused a significant stock market correction since 2000 with a fundamental deterioration in long-term prospects for equity markets.
But there are signs this view may be changing for certain institutional fund managers, although not retail savers. European equities have shown exceptional short-term powers of recovery during the rally that started in early October 2002. Since 10 October, the German Dax and Swedish OMX indices, both extreme bear market laggards, have led the way with good rallies. This trend in certain national stock markets directly mirrors the dramatic renaissance in the fortunes of the most depressed sectors, namely insurance, technology and telecoms.
Of course, this has happened before, in the final quarter of 2001 and in August 2002. Both rallies were subsequently reversed by a torrent of adverse economic and corporate news.
Given our more positive stance on US economic prospects and the comparative modesty of European equity valuations, we believe there is reason to expect the current rally to develop into a more durable market uptrend.
What steps should investors take to benefit from this more promising trend, consistent with a realistic attitude to risk?
The best approach, even for growth-orientated funds, is to devise an investment portfolio that combines both good quality growth companies and a strong element of defensive shares. Following such a long period of relative outperformance by defensive themes, the temptation to move wholeheartedly into fallen growth stocks might seem compelling.
But given the risk that economic and business recovery may not materialise as strongly as we would hope in 2003, maintaining a significant defensive element represents both a sound insurance policy and provides comfort for savers wanting to take a measured view.
The two key categories of the M&G European Smaller Companies fund illustrate the policy I have been describing. The more defensive element applies to companies with healthy balance sheets and cashflow characteristics, whose shares stand on modest valuations and offer considerable market liquidity. Prominent examples include Autoroutes du Sud, Logista, a Spanish distributor of tobacco and other products to retail outlets, and Sygenta, the leading agrochemicals group. Given the marketability of these stocks, we expect to be able to move quickly to take profits and reduce the fund's defensive element once we became more confident the stock market is strongly placed for sustained growth.
The second aspect of the fund's current strategy is to take advantage of share price weakness in companies whose growth prospects are very clear. This brief enables us to invest in smaller companies with outstanding growth prospects as well as blue chips. Companies in this category, include Anglo-Irish Bank, Puma, the branded sport goods distributor, and Ryanair. The ability to alter the weightings of these two categories gives the fund maximum flexibility.
It will take some time for retail savers to recover their appetite for European equities after a long phase of disappointment and decline. However, it is possible to find attractively valued shares, which stand to benefit from any improvement in market conditions.
While we believe investors are taking an excessively gloomy view on the long-term potential of European equities, further market volatility is possible before a more pronounced uptrend develops.
European equities are seen as dull and deserving of a discount for their supposed unexciting prospects.
In Europe, as elsewhere, there has been a huge divergence between the relatively healthy returns achieved by defensive sectors and losses suffered by growth areas.
Many people have confused a significant stock market correction since 2000 with a fundamental deterioration in stock markets.
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