Fund manager's comment/David Ballance
European equity markets continue to be weak and have now lost almost 18% in sterling terms since the start of the year. Although the recent reporting season has not been as bad as the US, it has underlined that Europe is not immune from the global slowdown.
The US Federal Reserve Board's response to the deterioration in the US economy has been swift and, by historical standards, relatively aggressive. Contrast this to Europe, where despite signs that growth is decelerating and latterly that inflation has peaked, the European Central Bank (ECB) has trimmed rates by just 25 basis points. Clearly, the ECB will not deviate from its fixation on price stability in the eurozone and taking CPI back below 2%.
Nonetheless, we believe that a further 25 basis point cut when the ECB returns from holiday, and a further cut by year end is now very likely. Indeed, we have to acknowledge the real danger ' that by acting late, the ECB may have to engage in more aggressive interest rate cuts than would otherwise have been the case.
Looking ahead, European equity markets undoubtedly face a difficult period, buffeted by overseas developments and earnings worries. Until signs emerge that US economic growth has stabilised and investors perceive that corporate earnings have bottomed, a sustainable market recovery is unlikely.
The key question is when the recovery is likely to come Our analysis suggests that the overvaluation of 1999 and the first quarter of 2000 has been worked off and European equities are now fair value relative to bonds.
However, while earnings estimates are still being cut and estimates for 2002 look vulnerable, confidence is unlikely to improve materially in the near term. Looking towards the end of the year, we are cautiously optimistic that a firmer trend may emerge with more rate cuts on board by then and earnings estimates closer to bottoming.
In terms of sectors, defensive areas have been leading the field for a while and, in some cases, are now trading at relative valuations last seen in 1991. Some of these stocks are clearly vulnerable to any change in sentiment. While we are still not out of the woods entirely on the growth orientated sectors, the long and painful period of underperformance has removed much of the overvaluations in this area.
For investors who are willing to take a long-term view, the outlook is more appealing. While the rejection of the new Takeover law for Europe was undeniably disappointing, the long-term case for investment in European equities, based on increased corporate restructuring and growing demand for equity assets from pension funds, remains intact.
The fundamental undervaluation of the euro, while unlikely to be worked off soon, also augments the region's appeal. Even if we are not going back to returns seen in the late 1990s, the long-term outlook looks bright.
• Growing demand for equity assets.
• Undervaluation of the euro.
• Valuations approaching fair value.
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