The world has been turned upside down. To the surprise of many, European shares have played the star...
The world has been turned upside down. To the surprise of many, European shares have played the star role in the post 12 March rally of western stock markets. Furthermore, the most vulnerable markets, Frankfurt and Amsterdam, which suffered most in the downturn, have shown the greatest powers of recovery.
Sheer relief that the gloomiest predictions (a protracted Iraq war and $50 oil) did not materialise was the main driving force behind the turnaround in sentiment. It was akin to the feeling when someone stops treading on your toes ' immediate relief, but not quite a reason for celebration. Moreover, risk aversion, as measured by tightening corporate bond spreads has been on a declining trend since last October.
That is the position that European equities currently occupy. Modestly valued, especially against bonds, whose prices have continued to move up since 12 March, but still facing an ambiguous outlook.
The market has new issues to worry about, but, ironically, these could also contain the seeds of hope. The balance of economic data, at least in northern Europe is pointing to low growth, or even stagnation in Germany. But the picture elsewhere, notably in Spain, Ireland and the prospective central European entrants to the EU is more positive. This raises the prospect of an increasing 'country effect', with a deliberate bias towards regions showing positive economic growth. The other key issue is the strength of the euro on forex markets and the impact of fluctuating currencies on economic growth and on company prospects.
The ECB seems unconcerned about the current euro/US $ parity of 1.17, which takes us back to its starting level in January 1999. Further US $ weakness will impose new pressures on the ECB to cut interest rates (as early as their next meeting in June), on governments to accelerate structural reform and on companies to accelerate restructuring plans.
This is a classic bad news, good news scenario, a possible crisis which forces everyone to take more radical action. Such a chain of events would be uncomfortable initially, but firm action could inspire more positive sentiment. By contrast, observe the disillusionment of investors over the denial and inaction of the authorities in Japan. That is a situation to be avoided at all costs.
Fortunately, the corporate sector is proving far more alert to the need for self-help than the ECB and European governments. Companies have been cutting costs and learning how to live in a low growth, highly competitive business environment.
This has been particularly true of the telecoms services sector, which once faced apparent ruin, but has proved effective in cutting debt, repairing margins and even persuading equity and bond holders to part with their money. Corporate restructuring can achieve impressive results; the best-managed European companies have been very active, although they have found progress easier to make in their overseas subsidiaries than at home. Steps must be taken to change that. The markets now sense that this will be forthcoming. There have also been signs of increasing M&A activity and of share sales by hard pressed corporate holders, evident, for example in the acquisition of Buderus by Bosch, of Banco Zaragazona by Barclays, and of bids by both Smith & Nephew and Zimmer for Centrepulse.
The consideration for most of these deals has been in cash. We expect private equity funds to be more active in acquiring small and mid-cap companies, as they have been in recent months in the UK.
All this sets fund managers some clear guidelines for stock selection. Look to increase weightings in countries with relatively healthy economic prospects or in companies from elsewhere, like Erste Bank, which are heavily exposed to such areas.
Focus on companies which stand to benefit from vigorous restructuring programmes; Arcelor, Credit Suisse and Deutsche Telecome are some of those in this category which we have been buying. Pay particularly close attention to well-managed companies in niche high growth areas, which are capable of prospering even against a strengthening currency background. Depfa Bank, Merloni and Puma all combine a positive outlook with modest share valuations.
To some people a glass is always half empty rather than half full. We believe strongly that that there are plenty of good investment opportunities in European stock markets, which are being disregarded by those who refuse to look behind the headlines.
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