European markets have enjoyed another sparkling year, the fourth in succession where returns have be...
European markets have enjoyed another sparkling year, the fourth in succession where returns have been very close to or exceeded 10%.
Last year took many by surprise and those who contend that European economic strength is at best fragile have again been confounded. So, with the benefit of hindsight it is interesting to look back at what has worked and where the surprises have come from, perhaps giving some guide as to what lies ahead in 2007.
The most important bridge between 2006 and 2007 is the strength and likely surprise of European economic growth. At the start of 2006 the target of 2.5% GDP growth was far from consensual, it caught many by surprise. The most interesting development is unemployment improvements in Germany and France driven by a better business environment and an easing of labour market restrictions.
The bears are too quick to pounce on the more difficult export environment in the forthcoming year and spend too little time on the sustainability and momentum behind what is happening in Europe. Sustainability is being driven by factors such as greater structural profitability and the German turnaround, as seen by the German business climate index IFO at close to a 15-year high.
Looking forward, the one certainty is global growth is slowing. The co-ordinated global tightening will take its toll and the US economy is likely to fall below trend. So for us the market leadership is likely to see a switch from the likes of commodity plays and global industrials to those companies with greater exposure to domestic consumption and European growth, while also not forgetting those companies that are exposed to greater structural growth in the markets they address. Within this framework our preference is for companies such as Metro AG, Prosieben, Lonza and Essilor.
The implicit factor is investors should become slightly more defensive and very much more domestic as the business cycle moves into the later stages. In doing so the preference has to be for large caps, for the principal factors of valuation and liquidity.
That is not to say investors will not find interesting smaller-cap holdings, but it is a fact they are becoming more difficult to find at the right price. Those in which to have high conviction include Praktiker, the German DIY retailer, and Imtech, the Dutch technical services company. However, the market overall will find large caps more attractive.
As a result of the level of takeovers, many traditionally less cyclical sectors have become more stretched on valuation grounds - the utilities sector being a prime example. Others have fallen out of favour - the healthcare sector has been a poor performer over recent periods mainly due to specific disappointments such as Sanofi and more general sector concerns with the likes of Roche.
This is likely to provide an interesting entry point for future outperformance. Similarly, value is emerging in many of the larger oil companies - valuations are approaching their lows despite the oil price being well defended at current levels.
Markets are not that easy to predict, otherwise outperformance would be easier to come by. So what are the outliers and where could the shocks come from? On a macro level the currency and energy prices are easy to cite. Similarly, all eyes will be on the Federal Reserve and how they manage the anticipated slowdown. In Europe there will be further monetary tightening, the effect of the German VAT increase and importantly the French elections, which could mark a turning point.
Suffice it to say this year will not be without its surprises, but Europe looks better placed than most.
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