Equity markets have been on a roller coaster ride over the summer months with the European excluding...
Equity markets have been on a roller coaster ride over the summer months with the European excluding UK markets being no exception.
Markets in this region have mirrored events in the wider world so far this year. Initially strong, they sold off in May and June because of concerns about inflation, only to recover in late summer on expectations of decent earnings results.
Investors have not been disappointed: the proportion of companies in the region beating expectations is still significantly above those failing to meet them. Clearly, the pace of earnings upgrades is slowing, but whether this will be dramatic depends increasingly on which path is taken by the global economy.
Central to current concerns is inflation. Monetary authorities around the world are unsure as to whether the steep rises in commodity prices, notably a high oil price exaggerated by geopolitical concerns, and more recently food, will lead to second round effects. In response, they have been raising the cost of borrowing to prevent higher inflation expectations becoming entrenched.
The bond markets appear to be taking the line that the US Federal Reserve will win the battle with inflation, with long bond yields falling back from the levels of a few months ago. The flipside of this is that tame inflation may come at the expense of a softening in US consumption.
Pessimists fear protracted weakness in the US housing market will translate into a recession; optimists hope the US can mirror the UK in 2005 and achieve a soft-landing. Either way, global growth may be in for a trickier period.
In such circumstances, it is comforting that the sector's markets are on undemanding valuations. Equities are trading on a 12-month forward P/E ratio of just 12 times, which seems attractive both in absolute terms and against historic averages.
Further support comes from corporate activity. Corporate borrowing costs may not be as cheap as previously but they are still low. This is evidenced by the number of cash bids from both private equity groups and companies seeking to arbitrage the differential between earnings yields and borrowing costs.
Corporate activity continues apace, with the Italian banking sector acting as a showcase. There have been several cross-border deals, both predator (Unicredito) and prey (Antonveneta) while the proposed Sanpaulo IMI and Banca Intesa tie-up marks the latest attempt to scale up to meet the challenges of globalisation.
While globalisation is forcing competitiveness on Europe ex UK companies, so shareholders agitating for change is encouraging boards to be more efficient. In the second quarter of 2006, firms in the region returned €30bn of capital to shareholders and capital expenditure has been more restrained as they conserve cashflow rather than over invest.
Such self-help is welcome news because the domestic economic environment is still challenging. German business confidence may be near a 15-year high but the recent pick-up in consumer confidence remains fragile.
The ECB is likely to be mindful that an aggressive interest rate policy risks pushing up the value of the euro and undermining the competitiveness of the region's exports at a time when demand from the US may begin to soften.
The most sensible strategy for investors is to ensure the companies they own have strong business models. In time, attractively valued firms with proven management and strong cashflows will reward investors and are likely to be less volatile should the global economy hit a rocky patch.key points
Inflation central to current concerns
Corporate activity continues apace
Companies conserving cashflow
Caring for children and elderly relatives
Similar to June 2007
Square Mile’s series of informal interviews
Fine reduced to £60,000
Two roles created