Continental equity markets are up 2.4% in euro terms in the year to date but have fallen 9.2% since ...
Continental equity markets are up 2.4% in euro terms in the year to date but have fallen 9.2% since the market's peak in early March, driven by the declining Nasdaq as many new economy stocks fall out of favour.
Europe's fortunes have become increasingly dependent on developments in the US with respect to the pace and magnitude of further US interest rate rises and the impact on growth.
Given the huge uncertainty surrounding these issues, visibility on the direction of European equities over the coming quarter has diminished while the high volatility of recent weeks looks set to persist.
The Fed's latest 50 basis points interest rate hike demonstrates a policy shift from gradualism to aggressiveness. This has heightened concerns among investors that a hard US landing could reverse the economic recovery in Euroland with a knock-on impact on earnings growth.
According to Morgan Stanley research, the impact of a US hard landing on Euroland would be small. They calculate the total impact of a 1% decline in US growth next year would hit Euroland GDP growth by less than 1%, bringing their 3.5% (consensus) target down to 2.5%.
Our central case remains cautiously optimistic. We believe the Fed can manufacture a soft landing and the outlook for Europe is positive. On the economy, the pace of industrial activity may have plateaued but it is at a high level. Consumer confidence is also buoyant and consumption should accelerate as fiscal policy eases to match an already accommodative monetary policy.
Headline inflation has probably peaked as the oil price impact filters out. This limits the impact on CPI, which should be further helped by the disinflationary effects of both deregulation and the internet. Nevertheless, the European Central Bank (ECB) is expected to raise interest rates by a further 50 basis points by the end of the year.
Admittedly, the euro's weakness, which has fallen to new lows in recent weeks, is causing some credibility concerns. Yet, the fundamentals remain unchanged. Short-term rates in the US are set to rise at least in line with Euroland rates while Euroland growth continues to lag the US.
Until investors' perceptions change on this issue a reversal of the euro seems unlikely. On a more positive note, the weak euro is doing no harm for Euroland exports and corporate competitiveness. Both factors may lead to upgrades on growth and earnings.
In terms of sector preferences we remain overweight IT hardware, and media. We are underweight telecoms along with all the technology sub-sectors, such as the web agencies, where earnings visibility is poor.
Gordon Strachan is manager of Five Arrows European equity funds at
Rothschild Asset Management
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