This year is likely to be another tough one for European investors in equities but in sectors such as pharmaceuticals and financials there are still money-making possibilities
Despite the weak global economic backdrop and the prospect of a sub-par economic recovery, we are still relatively optimistic in our expectation of European equity market returns for 2003.
The European economy seems likely to produce very lacklustre growth this year as weak domestic demand coincides with weak export growth.
Domestic demand is likely to be subdued owing to soft consumer spending that follows from fears over job security and low wage growth.
Business investment is also likely to remain poor with corporates choosing to continue repairing their balance sheets and generating free cashflow rather than to increase their capital expenditure. There is only limited scope for higher government spending, and indeed many eurozone countries are having to lower spending due to the restrictions of the growth and stability pact. Meanwhile, the outlook for exports is hindered by the subdued global economy and the strength of the euro.
European growth has been weak in part due to the inappropriateness of monetary policy. The ECB now appears to be subtly changing its policy and may well embrace more of a combined growth and inflation mandate rather than its previous inflation-only mandate.
This change in emphasis, the weak economy and the recent strength of the euro (it has now appreciated some 24% over the past 11 months against the US dollar) means that further interest rate cuts from the ECB now appear virtually inevitable.
Indeed, inflation expectations data points to a sharp fall in eurozone inflation over the next six to nine months, and lower rates could be necessary to prevent deflationary pressures gathering momentum.
Germany has been the best example of an economy suffering from inappropriate ECB monetary policy. Current GDP growth is minimal at around 0.5%, inflation is around 1%, unemployment is above four million and rising, exports are weak and government spending is now being reduced. Although data regarding business confidence in Germany (Zentrum fuer Europaeische Wirtschaft survey) and the most recent industrial production and factory orders data have shown signs of an improvement it seems difficult to see why this should be sustained.
The property boom that has been fuelling consumer spending in the UK, US and parts of Europe has not occurred in Germany, where residential property prices have actually been falling.
What Germany requires is more aggressive structural, particularly labour market, reform, though the recent re-election of the Social Democrats under Chancellor Schroeder will do precious little to address this issue. His return will only serve to maintain the status quo and is unlikely to bring about the necessary reform.
Valuations however already reflect many investors' concerns. Equity market valuations are cheap on a historic basis. As an example, dividend yields are now above short-term interest rates, while long-term interest rates are at extremely low real levels. Investors are still risk-averse and we believe that is a positive signal ' it would be more of a concern if investors were feeling overly bullish at present.
Analyst estimates of corporate profits in Europe have stopped deteriorating which has historically proved to be a good indicator of a turning point in the market. Valuations also seem to be well underpinned here as evidenced by the return of corporate activity. Late last year for example we saw Vivendi Universal receive indications of interest in its US media assets.
The group confirmed that it had received a bid for its US entertainment assets from Marvin Davis for an aggregate value of approximately $20bn. Also, HSBC purchased Household International and ENI's acquired Italgas after bidding for the 56% it did not own of the company.
Although the economic outlook remains one of muted recovery we still feel we are on an improving trend, with 2004 showing a return to reasonable growth. We continue to be cautious on most of the more defensive sectors of the stock market such as food, drink and tobacco where we feel valuations are stretched and top line growth will be minimal.
However, the sub-sector we favour within this area is pharmaceuticals where solid top-line growth is accompanied by strong free cash generation, solid balance sheets and undemanding valuations. Favoured names include Aventis, which recently reported strong sales during the first nine months of 2002, as well as Roche and Novartis.
The media sector was another poor performing sector last year, and any evidence of cyclical upturn would help the media content and ad agency stocks. There are high quality growth companies with solid franchises in niche areas such as billboard company JC Decaux.
We also favour business service group VNU, owing to the long term growth potential of its market research division.
Support services have also done poorly. This sector should offer leverage into any signs of an improving economy ' we favour stocks such as recruitment company Adecco, which recently reported market share gains in major markets for its Adecco Staffing division as well as substantial cost reductions.
We are also keen on Vedior and Buhrmann in this part of the market. In the autos sector we are favouring BMW and Porsche owing to their strong product launch profile and now undemanding valuations.
The auto mass market players are under pressure with sales expected to have peaked, especially in the US.
Other sectors we favour are financials and telecoms, where valuations again seem to be discounting a worse economic environment than we are expecting. In banks we are not anticipating a return to the same level of corporate debt defaults as experienced in previous economic downturns.
Indeed unlike stock prices, European credit spreads have rallied sharply over the past three months and are now close to their best levels for two years. Favoured names are centred on the faster growing European economies such as Ireland and Scandinavia where the retail franchises are well protected.
In the insurance sector the improving pricing environment will help profitability, while many groups have undertaken refinancings to improve their stretched financial positions.
In the telecoms sector we are expecting further corporate restructuring statements and more capital expenditure cuts to continue to boost a sector where valuations are, despite strong relative performance over the past six months, relatively undemanding.
Overall, 2003 is likely to be another tough year for European investors, but there are enough positive signs to believe there will at least be opportunities to make money.
Interest rate cuts from ECB are inevitable.
Valuations reflect investors concerns.
Estimates of corporate profits have stopped deteriorating.
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