Defused tensions, a lower oil price and a more positive outlook for the global economy have all contributed to a more sound background and a better outlook for European equities
What a difference a couple of months make. European equity markets have rallied by 20% in local currency terms since their March lows, and are now effectively flat over the year to date. This is strongly ahead of the returns from the MSCI World index over the same period, and has been something of a comfort for investors who have seen the value of their investments in continental Europe halve over the past three years.
The impetus behind this rally has, of course, been an improvement in investor sentiment. The outbreak of hostilities in Iraq after a long military build-up, and the speedy and successful conclusion to the conflict there, allowed investors to start to look beyond the immediate concerns towards the possibility of defused tensions, a lower oil price and a more positive outlook for the global economy.
The substantial narrowing in credit spreads over the same period has acted as a further impetus to the equity market, as more confident investors required a lower level of additional yield to compensate for investing in risky assets.
In turn, this means a lower level of repayments for companies on existing debt and the possibility of refinancing at a much more favourable rate.
In the same way that the decline in US short-term interest rates has encouraged homeowners to renegotiate the terms of their mortgages to free up spending money, we believe the contraction in credit spreads bodes well for corporate Europe and capital spending.
As is often the way, the rally in the equity market has been led by some of the stocks which declined most in the preceding months, particularly those with weaker credit ratings. Technology, insurance and industrial stocks have significantly outperformed while the more defensive sectors such as consumer staples and energy have tended to lag behind in this rally.
Our strategy in this changeable environment has been to focus on three main themes in the portfolios, where we see good prospects for encouraging returns for investors.
The first is restructuring. Here, we are looking for companies which have taken a close look at themselves and have made some significant changes, with the prospect of delivering an improvement in earnings regardless of the direction of the underlying equity markets. We would include holdings such as sportswear manufacturer Adidas-Salomon and a number of the larger telecoms companies in this category.
The second is undervalued opportunities. We see prospects for higher than expected earnings growth at these companies, while the shares continue to trade at a highly attractive valuation level for the growth on offer. We would group insurers Zurich Financial Services and Aegon, and stationary manufacturer Buhrmann within this category.
Finally, the third theme we have been implementing in our funds has been reasonably priced secure growth. Companies with these characteristics should offer a reasonably defensive stream of earnings and, again, we believe these should hold up relatively well in a range of market conditions. Examples of this theme can be seen in a number of the retail banks across Europe, such as Banco Popular and Allied Irish Bank.
Two examples of these themes in action in our portfolios can be see in the telecoms sector and in retail banking within Europe. The telecom sector has been a very good example of restructuring within Europe over the last year or so ' perhaps one of the few areas where European companies really have become more responsive to shareholder value. It took the combination of the high levels of debt incurred from the auction of third-generation mobile telephone licenses and sharp falls in equity markets to trigger the changes of attitude ' and in some cases management too ' for this to happen, but it has certainly been to the benefit of investors.
The former Dutch monopoly operator, KPN, was one of the first to embrace restructuring and focus on generating a positive free cash flow. This was followed by France Telecom, where an ambitious programme of change and the appointment of new management have started to turn around the prospects for this troubled company. We have seen strong returns for investors from our decision to take positive active positions in these two restructuring incumbent operators in the course of the last 12 months. We have now started to take some relative profits in our investments in this sector after the recent run-up in the market. While the restructuring story has been an attractive one, over the longer term mobile companies may be in a stronger position than incumbents if data volumes achieve forecast growth.
Retail banking, on the other hand, has been an example of our reasonably priced secure growth theme. At a time when merger and acquisition activity has been a poor source of revenue for investment banks, and insurers have struggled with the impact of falling markets on their solvency ratios, traditional high street banking has been a good source of relatively secure earnings growth. We have favoured two well positioned banks in two of the faster growing countries on the geographical periphery of Europe ' Ireland and Spain.
Allied Irish Bank has strong management, a robust franchise in its home market of Ireland and potential for further growth from the expansion of the US arms of the business.
This has been a core holding in our portfolios for some time now. We also favour domestically focused player Banco Popular Espanol, which is benefiting both from domestic economic growth in the retail and commercial banking businesses, and from encouraging sales of investment products as the slow process of pension reform begins in Europe. Both of these investments have contributed positively to relative performance in our portfolios.
The overall tilt we have given our portfolios has been to position them for gradually improving market levels, although not a rally led by some of the most volatile stocks. We have looked closely at the individual companies held in the portfolio to make sure that we are holding stocks where we still have a high level of conviction in the prospects for the company. The result of this is that we have focused on high quality companies which should participate in the event of a market recovery, yet still have some defensive qualities to support them in the event of a further period of market weakness.
Our cautious stance towards consumer staples and many of the energy stocks has benefited performance during this rally, and some of our other financial holdings have also been strong performers, contributing positively to performance. These include Credit Suisse, Aegon, Zurich Financial Services and Amvescap ' the very stocks which fell so sharply in the early months of the year. On the other hand, some of our other holdings, typically the traditional growth-at-a-reasonable-price stocks such as publisher VNU, have lagged in the rally.
It is difficult to say with great conviction where the European equity markets will go from here. Clearly, we are living through uncertain times and investor aversion to this has been reflected in the movement of continental European equity markets. European equity markets look to be on the cheap side of fair value, and look especially attractive relative to history as well as to government bonds. At these levels, many of these risks are priced into the market. The question, of course, is how much.
Improved investor sentiment has led to strong gains in European markets recently.
Restructuring, undervalued opportunities and reasonably priced secure growth are the core drivers of growth.
Investor aversion to risk has moved markets but it now looks fully priced in.
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