Fund manager's comment/Susan Smith
As we approach the first anniversary of the current bear market, Europeans can no longer afford to be complacent about their immunity against weakness in the US. Although exports are a small part of eurozone GDP, an increasing proportion of European profits stem from US subsidiaries.
The most immediate problem is the overhang from the high level of investment in technology during the boom years of the late 1990s. Now, there is significant overcapacity, particularly in telecoms, which are also suffering from high levels of debt after overpaying for third generation mobile licences. There are signs that inventories are falling to more tolerable levels, but many technology firms will never see a return to their former glory.
Redundancies have soared and the steady fall in eurozone unemployment over the past four years has stalled, real wages are falling, and disposable incomes have been further eroded by the sharp rise in energy and food prices. Moreover, investment is falling, and it was only because weak demand prompted a sharp fall in imports that the eurozone had any growth at all in the first quarter of the year.
We believe the European economic outlook is not so bleak. Inflation pressures have eased significantly, and growing evidence of a slowdown means that the ECB is unlikely to wait until inflation has fallen below its 2% target before cutting rates.
There is much scope for a sharp reduction in eurozone interest rates, and the next cut could be as soon as 30 August, possibly following a further reduction from the US Federal Reserve a week earlier.
Either way, the aggressive reductions in the US should already be filtering through to the real economy, and consumers on both sides of the Atlantic should reap the rewards.
The development of an equity culture will support the long-term performance of European share prices. Monetary union has replaced small, national equity markets with something both broader and deeper, with a much larger pool of investors on which to draw. This has made it cheaper for firms to raise finance through the markets, rather than rely on bank loans, while the retirement needs of an ageing workforce have also boosted the demand for equities. This means shareholder value has become the primary objective of management as companies compete for investors' cash.
We also expect the rate of merger and acquisition activity to continue and even accelerate in response to the current pressure on profit margins. Corporate restructuring results in a more efficient allocation of resources and releases value to shareholders. Negative earnings momentum is a big obstacle to the recovery in European stock markets. But signs of recovery should lead to a big improvement in sentiment. European equities are not expensive, and the first tangible evidence that the worst is now behind us could trigger a sharp recovery.
• Lower interest rates and recovery.
• Development of an equity culture.
• Extensive corporate restructuring.
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