European equity markets have had a difficult start to the year. Investor sentiment has deteriorated ...
European equity markets have had a difficult start to the year. Investor sentiment has deteriorated in sympathy with US markets and, as a result, the major European indices have fallen since the beginning of 2001.
However, the case for investing in Europe remains compelling. In the short to medium term, the macroeconomic fundamentals are stronger for Europe than they are for the US. Over a longer time horizon, the argument for Europe is equally persuasive because of the significant benefits that restructuring and reforms at both corporate and government level will continue to bring about.
At present, the US economy is clearly slowing. This has led many observers to start predicting doom and gloom scenarios for the US, arguing that Europe will automatically follow where the United States leads.
The impact of the slowdown in the US economy has certainly been felt in Europe. However, we are forecasting that US growth will likely bottom in the first half of the year given decisive action by the Federal Reserve, which should result in a brighter economic performance and sustained recovery in the second half of this year.
This, in turn, will improve European growth prospects. Growth in Europe in 2000 was at its highest level since the German reunification boom in 1991 and growth in the EU12 is set to outpace that in the US in 2001.
The growth will be driven in large part by improving private consumption supported by tax cuts, an improving labour market, lower oil prices and lower inflation.
To a large extent, Europe is playing a catch-up game with the US. Many of the factors behind the US boom over the 1990s, including productivity gains and increased corporate efficiency and flexibility, are also happening in Europe, albeit with a lag. This is crucial because markets have not fully discounted the massive impact that such restructuring and deregulation will have.
European companies are undertaking change and reform in a number of fundamental ways. Over the past decade, they have become much more responsive to the needs of shareholders and, through increased liberalisation of trade, have been forced to compete against multinational rivals, particularly those from the US and Japan.
While operating margins and return on capital still lag behind those in the US, the gap continues to narrow. Similarly, although productivity is lower in Europe than in the US, Europe is catching up through investment in IT and communications.
The quality of management in corporate Europe has also improved significantly over the last decade and continues to do so. This is manifesting itself in better inventory and cash flow management practices as well as ongoing balance sheet restructuring. European corporates are also increasing their efficiency by outsourcing non-core functions and through industry consolidation.
European companies are not carrying out these changes in isolation. The corporate restructuring has been accompanied by significant shifts in Government policy. European Government initiatives are deregulating the labour market, making it more flexible and responsive to the needs of companies.
It has become easier and more commonplace, for example, to hire (and fire) temporary or part-time workers. In addition, corporate taxation has been falling over the past decade across Europe and will continue to decrease in the future.
European Governments have also undertaken an extensive programme of privatisation, particularly in the area of utilities.
Pensions reform is also having a huge impact on equity market liquidity. European Governments are increasingly sending the message that individuals have to take a greater responsibility for their retirement planning and financial future. This development has coincided with lower real interest rates than existed throughout the 1970s and 1980s. In a high interest rate environment, individuals were content with holding a large proportion of their wealth in the form of fixed income investments.
As real interest rates have come down over the past decade, the relative returns available on equities have started to look more attractive. As a result, there is a growing appetite for equity investment and this has been encouraged by many national Governments.
An equity culture is beginning to take hold, boosted in many countries by the privatisation of national industries.
Flows into mutual funds (particularly those holding equities) have been growing in Europe, as have direct holdings of shares by individuals. All this is serving to increase liquidity in European markets. The degree of market capitalisation relative to GDP in continental Europe is significantly lower than in the US, leaving scope for growth.
What does our positive economic view for the second half of 2001 and 2002 mean in practical terms for the American Express portfolios? We believe defensive areas of the market that have already re-rated to reflect the defensibility and transparency of their earnings will increasingly underperform as the markets focus on their stretched valuations. Consequently, we have significantly reduced our defensive holdings such as pharmaceuticals, food retailers and utilities.
The market will then look to own sectors whose earnings have been depressed as the economy has slowed and/or whose earnings will accelerate as rates are cut and economic conditions improve into the second half.
Our portfolios are now positioned across a range of these areas of the market that will benefit from interest rate cuts and accelerating growth. This includes sectors such as banks, general industrials, building and construction, media and certain areas of technology, such as semiconductors, which are cyclical and will benefit from improving economic activity.
The risk appetite of the market has certainly been on a downward trend and managers are currently sitting with very defensive portfolios and large holdings of cash. Market conditions will remain volatile until the uncertainty about the state of the economy and corporate profits is resolved.
However, we have very strong views on the outlook for Europe in 2001 and maintain that the recovery will be swifter and more pronounced than the market is currently anticipating.
A barbell strategy of 'old economy' cyclicality coupled with cyclicality in media and technology and a low level of exposure to defensive sectors will outperform significantly over the course of 2001. It is in periods of extreme nervousness and polarised valuations that substantial investment rewards can be made.
Gavin Corr is chief investment director, Europe, at American Express Asset Management
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