In 2001, investors in Europe suffered much the same fate as their UK and US counterparts. In 2002, the prospects are that much brighter, thanks to lower share price levels and structural reforms in the pipeline
Look back just over a year and Europe was being tipped as one of the best performing markets for 2001.
The theory at the time was that, although the US would slow down, Europe would not be seriously affected. This rosy outlook was largely based on what now appears to be a rather dubious argument: as the European economy had not kept pace with the US on the way up, its performance would be similarly muted on the downside. The European Central Bank adopted a similarly optimistic line, refusing to push down interest rates with Alan Greenspan's rapidity.
This supposed benign environment encouraged predictions that the FTSE Eurotop 300 would end 2001 at around 1,800, a rise of about 17%. In the event, the assumption of Europe's economic immunity proved unfounded and the FTSE Eurotop 300 ended 2001 at 1261.06, an eventual fall of over 17%.
A salutory lesson
The salutary lesson to be learned was that there still needed to be a strong US economy for Europe to flourish. Admittedly the confidence-sapping effect of the 11 September attacks did not help but those thinking that the European economies would take over the global growth driving seat when the US backed off have had to think again.
We enter 2002 in a rather different mood. The prospects for the US locomotive resuming its lead role are at best uncertain. The economic news from across the Atlantic has been mixed, with signs of recovery alternatively countered by gloomy earnings news from major US companies. The notion of jam tomorrow ' a strong US pick-up in the second half of the year ' is that much less definite than it seemed late last year. The much-vaunted V-shaped recession may be moving towards a U-shape, W-shape or even (whisper it) L-shape.
In Europe, the arrival of 2002 marked the introduction of euro notes and coins. This gave the currency a brief spurt of strength before it drifted back to December 2001 levels. It also put Europe in the headlines again, particularly in the generally eurosceptic UK press. After three years as a virtual currency, the launch of the real money euro has gone remarkably smoothly. Confidence would have taken a severe knock, had there been the glitches that some of the more zealous europhobes had gleefully anticipated.
From an investment viewpoint, the success of the launch is all that really matters as far as the arrival of euro cash is concerned. It has not altered anything in the eurozone, although it has encouraged the outsiders (Denmark, Sweden and the UK) to ponder their exclusion. Over the long term, the euro adds another layer of competition to pricing, but even this is limited by such practicalities as different packaging and tastes across Europe. Of more relevance to investors is the economic outlook in Europe and its market valuations.
On the economic front, the latest indicator produced for the Financial Times, FT Deutschland and Les Echos suggests that in the fourth quarter of last year, year-on-year economic growth was 0.9% across the eurozone.
The growth between October and December is put at 0.2%, which is better than Eurostat's figure 0.1% for the third quarter. The consensus prediction for eurozone growth in 2002 is around 1.2%, which as ever hides a wide dispersion between Ireland, at over 3.5% and Germany struggling to produce 0.7%. The corresponding figure for the UK, ably assisted by spendthrift consumers and the Government, is 2%.
Does that make Europe an interesting investment proposition? The answer from fund managers is positive. The latest monthly survey of global portfolio managers from Merrill Lynch shows that Europe ranks virtually alongside the US and emerging markets as an area in which managers favour overweighting equity exposure. There are a number of reasons for this:
l The US market, the biggest global market by far, is considered by many managers to be overvalued at current levels. The bounce back from the lows following the terrorist attacks has been strong and potentially taken credit for future growth which is to be delayed. For example, at the end of 2001, the price/earnings ratio on the S&P 500 was over 40. European valuations are much less stratospheric, which is a source of comfort when the outlook for the E element of the P/E ratio is unclear.
l There is still considerable scope for structural reform in Europe. For all the exhortations of the ECB and Messrs Brown and Blair, EU members have been slow to liberalise their economies. Nowhere is this more apparent than in Germany, where Gerhard SchrÃ¶der is facing an election in September against a backdrop of four million unemployed. SchrÃ¶der has fought to introduce some structural reforms but it has been a protracted and many would say timid process.
l The abolition of capital gains tax on disposal of industrial cross-holdings is a good example. The idea was first floated in 1999, but it has only just taken effect. In theory, the exemption from tax will set in train a wave of corporate restructuring, as Germany's major companies release locked-up capital for more efficient use. Investors stand to benefit as companies achieve higher returns on capital and greater market liquidity results from the unwinding of cross-shareholdings. Reductions in corporation tax, introduced at the same time, will also help investors. However, Germany's strict labour market laws remain an obstacle. There is the chance of reform here, but only once the election is over and the support of the unions becomes less crucial to Mr SchrÃ¶der's SPD.
In Europe's othermajor economies, structural reform also holds out the prospect for investors that companies will be able to become more efficient and share values rise accordingly.
One specific area of structural reform that will be of major importance to investors is European pensions provision. This is still dominated by the state, but the funding of future benefits does not sit comfortably with the Maastricht debt criteria. The pensions issue will have to be addressed soon, if only because continued deferral carries too much financial risk. That ought to give a green light for greater investment in European equity markets, as money purchase schemes become widespread.
Germany has taken a first step on the path to reform by introducing limited tax relief for employee contributions to pension funds. France, Italy and Spain all face similar pension problems to Germany but have been even more reluctant to face the consequences.
At present the European stock markets still lag behind their Anglo-Saxon counterparts, but an influx of long-term pension money could help to change this.
Monetary conditions have turned very supportive to financial assets in Europe, where monetary policy has been conspicuously behind the curve. Broad money growth is rising at an 8% annual rate in Euroland, while nominal growth in the real economy is perhaps 4%, leaving plenty of fuel to push stock prices higher.
During 2002, prospects for interest rates ought to be relatively benign. The ECB's 2% inflation target is now within sight ' the December HICP figure was 2.1% ' and even the somewhat unpredictable Wim Duisenberg is seems more likely to cut rather than raise rates in the short term.
In 2001, investors in Europe suffered much the same fate as their UK and US counterparts. In 2002, the prospects for Europe are that much brighter, thanks to lower share price levels and structural reforms that are finally starting to come through.
We remain overweight in Continental Europe and our confidence in a period of outperformance is building. An easier monetary environment is finally in place and some sort of recovery will occur late this year. We favour old economy-style cylicals in industries that have not added capacity for some time, as a result of which companies find themselves with pricing power. If further encouragement were needed, then ponder the fact that in some basic industries, such as chemical and energy, European companies are at a 40% discount to their US peers.
Last year, year-on-year economic growth was 0.9% across the eurozone.
In Germany, capital gains tax exemptions will set a wave of corporate restructuring in motion.
Basic industries, such as chemical and energy, European companies are at a 40% discount to their US peers.
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