Since the US market peaked three years ago, European equity markets (excluding the UK) have tum...
Since the US market peaked three years ago, European equity markets (excluding the UK) have tumbled further than other major blocks. The recovery of the euro in 2002 narrowed the extent of underperformance by Europe, but it still remained wide.
The development of Euroland evidently did not provide any notably positive market themes. While there has been progress in unifying financial markets allowing non-government bond markets to blossom, major supply side reforms were not apparent. Critically, there was no momentum towards labour market de-regulation or pension fund reform in Germany.
Looking forward, the investment environment is now dominated by geo-political developments. Day-to-day volatility is exceptional. Neither 'best case' nor 'worst case' scenarios appear to be discounted. A widely-expected 'relief rally' has got underway, even before the war started, and stocks and bonds globally continue to reflect the direction taken on Wall Street.
In Europe itself, the European Central Bank is expected to cut interest rates by 50bps to 2% by year-end. The Stability Pact appears unlikely to be enforced, allowing Germany, France and Italy in particular to overshoot limits on their deficits. But it is unlikely policies will turn reflationary with any force.
Oil prices are expected to settle in a $20-$30 range, boosting incomes. Oil price trends and the stronger euro are likely to allow inflation to dip under 2% towards 1.5%. Real interest rates may fall a little.
While they are positive in Germany, they are close to zero or negative in Holland, Spain, France and Italy. These developments support domestic demand, but the labour markets may weaken more noticeably than in 2002. Capital investment is likely to remain sluggish.
Consensus expectations for GDP growth in Euroland have been downgraded to 1.1% for 2003 and to 2.1% in 2004. The risks are towards lower growth in 2003 and higher growth in 2004. The main risks are geopolitical and a much stronger euro.
On balance we expect the US dollar to weaken, but with the dollar/euro at 1.05-1.15 is likely to capture most of the action over three to six months.
Within Europe, the differential in growth between Germany in the slow lane and elsewhere is likely to remain. The fastest growth is expected to be in Spain, Sweden and Ireland in continental Europe.
In the near term, developments in Iraq are likely to remain overriding. Trends on Wall Street will be inescapable.
We do not see a major drive to European markets from changes in economic policies, unlike turning points in more usual cyclically driven bear markets. In the initial stages of recovery, continental European markets may perform relatively strongly (high beta). But is hard to see this persisting, as just a moderate growth cycle is likely to develop.
Consensus forecasts for corporate earnings growth across Euroland at 22% for 2003 are probably too high now, and reflect heavy write-downs last year, but some acceleration in 2004 is probable. Valuations are generally regarded as attractive on most measures and European markets appear cheaper than the US.
In particular, market dividend yields at 3% are above cash rates and equities appear cheaper against bonds than at any time since the 1960s. Markets are currently trading on a 2003 P/E multiple of 12.4 or an earnings yield of 8.1. Unless deflation takes hold, this at least suggests limited downside.
The supply/demand balance has improved. We do not expect renewed forced selling by financial institutions and rights issues will not come as a surprise. Many long-term funds now have historically low weighting in equities and holdings have been reduced by more than appears to be the case in the US or UK. There have been some signs of renewed merger and acquisition activity.
When equity confidence returns, asset class preferences are likely to shift away from fixed income, which now appears expensive, into equities. Initial movements can be sharp.
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