European market outlook
By Richard Pease, manager of the New Star European Growth Fund
European companies have only recently been subjected to the more vigorous demands from aggressive shareholders to maximise returns. This, in turn, has helped encourage European management to rationalise and pursue synergistic mergers and acquisitions. It is difficult to see any let up in this process, particularly given the large amount of private equity and leveraged buy-out funds now focused on Europe, as well as the proliferation of performance-hungry hedge funds.
Corporate activity has come in many forms, ranging from the domestic consolidation of Italian banking groups SanPaulo-IMI and Banca Intesa, to the cross-border combination of Iberdola and Scottish Power, to create a power company with global interests and a leading edge in renewable power generation. We are probably witnessing the embryonic stages as companies increasingly bulk up to meet the challenges of globalisation. Obvious candidates that remain relatively untouched and ripe for consolidation include the fragmented Scandinavian banking scene.
While corporate activity is giving a boost to share prices, higher earnings, helped by an improved domestic economy are also providing support. Germany, the main engine of Europe has benefited from a recovery both in terms of its capital goods companies and its construction market and this is starting to feed through into more upbeat consumer demand. Furthermore, the German trades unions appear to be increasingly pragmatic when it comes to allowing more flexible labour conditions, particularly when faced with the real possibility of investment in manufacturing moving eastwards. As such, German unemployment has fallen below the psychological four million mark as changing attitudes have made the country more competitive. France appears to be somewhat lagging in terms of labour flexibility but major employers such as Peugeot and Michelin are now discussing serious cost-cutting measures to compete in world markets.
The European economy may be stronger but it is not yet at the stage where the European Central Bank (ECB) feels forced to raise interest rates aggressively. Equity markets could be unsettled if the ECB became more hawkish and moves away from its measured approach, with rises heavily signalled in advance. It is somewhat comforting therefore that it did not follow the Bank of England's example with a shock rise in January.
The other concern for equity markets is the relative strength of the euro versus the dollar, which is impacting on the competitiveness of Europe's manufacturing base. It has also negatively affected European companies with significant subsidiaries in the US. However, most major European companies appear to have managed their dollar exposure reasonably satisfactorily. In some ways the stronger currency has been helpful as it has taken pressure off the ECB to raise interest rates more steeply while dampening the impact of higher oil prices: an important consideration for a region, which, Norway aside, is a heavy oil and gas importer.
With European equity markets having enjoyed four straight years of solid gains, observers naturally question whether markets are looking expensive. Clearly, in some areas, such as Spain, valuations appear more demanding. Earnings growth has, however, been impressive and this has prevented price/earnings ratios from widening despite the rise in markets. In relative terms valuations still compare favourably against other global markets such as the US and Japan.
As always, following a strong bull run, stock selection becomes increasingly important. Provided investors concentrate on cash-generative companies with robust business models run by proven management, they should be able to look forward to another satisfactory year of positive returns from European equities.
Bull points
High M&A activity
Improving economy
Attractive valuations
Bear points
Slow labour reform
Strong euro
Rising interest rates
Past performance is not necessarily a guide to future performance. The opinions expressed here represent the views of the fund manager at the time of preparation and should not be interpreted as investment advice.