After a volatile 2000 for European equity markets, the outlook for the next 12 months appears somewh...
After a volatile 2000 for European equity markets, the outlook for the next 12 months appears somewhat brighter. This view is based on a number of considerations and perhaps the most important of these is that, relative to the US, Europe has witnessed only a moderate slowdown in activity and earnings growth, reflecting stable economic growth and continuing restructuring.
We believe interest rates in Europe have peaked and are likely to decline during the course of the year, providing support to equity markets, while further cuts in US rates should strengthen investor confidence. A more favourable bond/equity valuation also suggests that investors' concerns regarding earnings risks from slowing economic growth are already being discounted to some extent. In addition, the impact on profits growth from restructuring, merger & acquisition activity and tax reform is unlikely to fade.
The next few months will be difficult though, as investors focus on the slowdown in global growth, as well as poor fourth quarter earnings results and profit warnings.
European markets' performance throughout 2000 was characterised by significant volatility within sectors and stocks. Concern that the global economy was slowing, spearheaded by a more rapid slowdown in the US, was the dominant influence on sector performance worldwide.
Outperforming industries tended to be those regarded as defensive, in particular utilities, healthcare, food producers and some financial stocks.
By contrast, underperformance was concentrated in those areas where earnings were more likely to be affected by the economic cycle, including many industrials and the headline-catching technology and telecoms companies. The resultant aggressive sector rotation has had a material impact on relative valuations at sector and stock level, reflecting perceptions of a difficult profits background. Indeed, implied earnings growth and valuations in the technology and telecoms sectors are very low by historical standards.
In the first half of 2000, earnings momentum in Europe was strong and upgrades exceeded downgrades by the highest amount since the 1980s. This momentum has faded, reflecting the impact of slowing global growth and the rise in oil prices. However, the overall growth rate in Europe is still quite strong and is holding up better than other markets like the US, where downgrades have been more material.
Despite investors' concerns about the US economy, it is interesting to note that French consumer confidence has just hit an all-time high. Domestic consumption is likely to be a key driver to economic growth in Europe, alongside robust capital expenditure and export growth. In this respect, we are not expecting a sharp drop in the pace of economic growth, and continue to anticipate an annual rate of around 2.5% in 2001. This would be consistent with solid, but not spectacular, earnings growth. With inflation under control, there is also scope for monetary easing and we expect interest rates to begin falling in the second half of the year.
Likewise, the prospect of further interest rate cuts in the US is expected to have a positive influence on European markets, as fears that the US economy may be heading for recession abate. We expect the Federal Reserve's unexpectedly aggressive cut in interest rates early in January should start to stabilise the US market.
By the second half of 2001, additional rate cuts should provide further support equity markets globally and provide compensation for profits warnings expected from the corporate sector.
Cuts in US interest rates may also prove to be the turning point for equity investor sentiment, which has been so poor of late, though we would expect this to change gradually rather than immediately.
In addition, European equity markets' rating against bonds has become more attractive over the last twelve months. Equity markets have fallen quite considerably led by declines in 'new economy' valuations, earnings have risen, and bond yields have fallen. In our view, equities are now slightly below fair value against bonds, implying that some of the bad news on earnings is already reflected in the price.
While Europe may be on a slightly more expensive rating than elsewhere in the world, we are more comfortable with the prevailing bond/equity valuation and believe it will be supportive of equity markets going forward. Moreover, we believe strong merger & acquisition activity and other corporate restructuring, as well as tax reform, will produce better equity conditions, driven by interest rate cuts. An increase in individual equity holdings is also likely to prove positive for European equities.
But this does not mean volatility will disappear entirely. Over the past six months, growth in Gross Domestic Product and industrial production have decelerated in most major economies, particularly in the US. Oil prices are also still quite high and there are likely to be a number of profit warnings and earnings downgrades from both sides of the Atlantic as these economies continue to slow. Investor uncertainty surrounding interest rates cuts, particularly in the US, is also likely to put pressure on European equity markets.
Accounting for the potential of further volatility, we are likely to remain selective with regard to technology and telecoms stocks, unlike at the beginning of 2000 when our holdings were more highly concentrated in these 'new economy' sectors. However, we believe these sectors are more likely to outperform defensive sectors such as beverages and utilities over the longer term. We are confident there remains a wealth of strong stories at the individual stock level in Europe, both within the world of larger companies
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