During the very early part of 2006 equity market returns have certainly been impressive. This is par...
During the very early part of 2006 equity market returns have certainly been impressive. This is partly due to strong ongoing corporate results, and equity valuations that appear undemanding. But what has really stood out as the catalyst for stronger-than-anticipated markets has been merger and acquisition (M&A) activity.
During 2005 global M&A activity increased by over 40% and this trend has continued into 2006 with a raft of high-profile news-flow, not least in the UK and Europe. Somewhat unusually, the share prices of most recent acquirers have been well supported, reflecting that companies are seen to be paying realistic levels for their targets and that transactions do not require a degree of lateral thinking to justify their strategic aims.
With the markets currently so well-disposed to such activity, corporates will be encouraged to pursue the M&A route and, while they may become gradually less-disciplined on price, the trend should remain very supportive for some time to come, allowing equity markets to continue their positive run.
Throughout the strong equity market recovery since late 2002, valuations have remained stable, as corporate profitability moved substantially higher. Of particular note on this front is Europe, where corporate profitability has reached a 30-year high. This leaves valuations standing well-within the realms of reality, especially when taking into account the persistently low level of long-term real interest rates. Therefore, scope exists for valuation expansion to more than offset any slowing in corporate earnings growth.
Underlying this, specific sector based trends are also notable, in particular, the de-rating of multiples within certain sectors. Both technology and telecoms clearly needed a return to more sensible levels after the excesses of the late 1990s. However, the energy sector has also been de-rated, with some investors cautioning that share prices reflect "peak earnings". However, others disagree with this view and expect energy prices to remain structurally high for the foreseeable future.
With M&A activity likely to remain high and valuations looking realistic, equities continue to look attractive in relation to other asset classes. Furthermore, the energy sector could benefit from a positive valuation re-rating as markets begin to accept prices will remain higher for longer than is currently anticipated.
Geographically, despite strong progress over the last year, Europe will continue to offer attractive returns to investors, driven by strong corporate profitability, exceptionally robust balance sheets, and a gradually improving consumer picture. In the US, while many of the same themes exist, we continue to hold reservations over the consumer and, as such, favour companies with exposure to corporate rather than consumer spending.
Turning to fixed interest, having previously brushed aside tighter monetary conditions in the US, the world's markets now face the phenomenon on a more globalised basis. The European Central Bank has undertaken two interest rate increases, and the Bank of Japan has signalled an end to its ultra-easy monetary regime.
This has led expectations for interest rates to become a little extended in the US and Europe. In the US, consumers still face increased borrowing costs, higher energy prices, limited wage growth and a less-supportive housing market. In Europe, the domestic economy remains in the fledgling stages of expansion. The potential for a mild slowdown in the US economy, along with a rising euro, leaves many struggling to see why eurozone interest rates need to rise significantly. All of this will help bond markets to remain reasonably well-supported in the months ahead.
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