The aggressive interest rate cuts and fiscal stimulus introduced in the wake of the terrorist attacks in September should provide a strong basis for a recovery in the second half of this year
The European equity market offers great expectations for the next 12 months. After a disappointing 2001, during which major indices declined around 20% in sterling terms, we can at last look forward to positive returns.
Like the UK, European markets rallied well from their lows in September last year following the terrorist attacks in the US. The aggressive interest rate cuts and fiscal stimulus seen since then in the US, UK and Europe should have the desired economic affect and provide a base for a global recovery this year.
That said, the the recovery will probably not be seen until the second half of 2002 as there is always a delay after changes in monetary policy take place before they start having an impact on the economy.
As the global economy starts to recover, Europe will perform particularly well. Furthermore, valuations against bonds currently look attractive and any more interest rate cuts will help this further.
Last year brought significant and far-reaching changes for Europe. For example, tax and pension reforms in Germany, Europe's largest economy, are set to redefine the corporate landscape. They will remove capital gains tax in Germany, and should provide the catalyst for a move away from the current conglomerate business model.
This suggests merger and acquisition activity will pick up significantly as corporates are given the opportunity to unlock hidden reserves and redeploy dead capital into core activities. The overall effect we are likely to see is a more efficient use of capital, which will inevitably improve returns.
As with the rest of Europe, pension reform is proving a necessity in Germany as the current state system is creaking under the burden of a rapidly ageing population. Through tax breaks, the onus is being put more on private pension provision, which means the amount of new capital that flows to the equity market is likely to be considerable.
On the corporate front, Europe appears to be in better shape than it was during the last recession. Debt levels do not appear to be overly burdensome, particularly given the current low level of interest rates. Management also appears to have a tighter control over inventory levels and enhanced flexibility over labour costs. The pace of corporate restructuring is clearly improving and this augurs well for profitability going forward.
This restructuring is moving Europe in the right direction and it is only a matter of time before the markets acknowledge this.
Fortunately, inflation, always a potential threat to financial market stability, does not appear to be an issue for Europe at the moment. With the oil price in decline and the euro appearing to have found its base, economic conditions certainly look to be on a sounder footing than ever before. As a result, there is scope for deeper interest rate cuts to be made if needed to further stimulate growth.
Last month saw the euro transition ' a move from an accounting currency to the introduction of three-dimensional euro notes and coins. Some 300 million people in twelve countries across Europe share the single currency, the first tangible evidence of the EU's ever-closer economic ties.
We have probably already witnessed the majority of increased consumer activity resulting from the black economy areas of Europe. Spending of undeclared or ill-gotten earnings hoarded under the mattress is thought to partially explain the strong demand for durable consumer goods through 2001.
However, the introduction of euro notes and coins could well bring long-term benefits as we begin to see an increase in consumer price transparency across borders. This process has already begun, with pricing differentials for big ticket items, such as cars, already narrowing. There is still plenty of scope for this to progress further, however.
While the euro has come in for much criticism since its launch, mostly because of its almost instant fall against sterling and the dollar, it has performed much better than many experts predicted through a period of major international unrest. The terrorist attacks in the US, that country's economic slowdown and the Argentine currency crisis have all left the euro virtually unscathed, and it appears to have now found a valuation floor.
With the fiscal and corporate reforms we are expecting this year, combined with modest economic growth and low inflation, there is good potential for the euro to gain in strength during 2002, boosting the potential return for sterling investors.
Monetary policy is likely to remain supportive, restructuring potential is still to be fully recognised in market valuations and pension and tax reform offers longer-term benefits. Add in the potential for a positive currency contribution and the outlook for 2002 is much improved.
Bearing all this in mind, we have been positioning our European portfolios for recovery since the end of 2001. Looking ahead, the economic recovery we expect in the second half of 2002 should set the stage for a good profit recovery in 2003. Consequently, we have been buying cyclicals and growth stocks, where the potential for a profit recovery is strongest, while selling defensives, where profit growth is modest or valuations excessive.
The pharmaceutical sector looks particularly vulnerable given slowing growth rates and pricing concerns, while utilities look expensive relative to the market.
Tax and pension reforms in Germany are set to redefine the corporate landscape.
The introduction of euro notes and coins could bring about an increase in consumer price transparency across borders.
Despite coming in for criticism, the euro has performed well through a period of major international unrest.
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