Market Outlook - Europe - Nick Sheridan

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Forecasting Continental European stockmarket movements is particularly difficult in current conditions. The overriding factor is macroeconomic, with investors taking a view on whether the US will slip into a sustained recession. The world's central banks are unable to shed meaningful light and it is likely to be months before a conclusive steer is given on which way the US will tip.

The bears point to banks in Europe being reliant on structured products and leveraged balance sheets - avenues closed by the credit crunch. Consumers in mature markets are generally over-geared, with education costs rising, house prices inflated and pension provision under-funded. As the impact of an ageing population bites, spending may be reined in, possibly for a prolonged period.

The bull case, however, can also be compelling. Structurally the eurozone and the companies operating within its borders have changed from a decade ago. At a corporate level, costs are being stripped out, production moved overseas effectively and returns on invested capital increased. The European Central Bank also retains room to manoeuvre.

Valuations are also supportive. In 2007 retail investors sold equities at levels in excess of previous cycles and there are now reasons for buyers to return. Analysts forecast potential returns of up to 25% by the year end, with the prospective price/earnings ratio for European equities at 10.7, its lowest in 15 years*. For asset allocators, equities look particularly cheap relative to bonds, with the risk-adjusted yield gap between the two at 3.65 percentage points, the widest since 1980*. Large corporate buyback programmes should add further support. 

While valuations support Continental European equities, a deep US recession could negate all. Until further data sheds light on the health of the financial sector, the US consumer and the scope for additional monetary easing, stockmarkets will struggle to price risk accurately. In the interim, volatility is likely to remain high, with stockmarkets driven by fear rather than fundamental analysis. Central banks must prove their mettle and, if successful, a stockmarket rebound is likely to follow. With the jury out, a focus on attractively-valued companies with debt-light balance sheets appears the most prudent approach.

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*Figures at 25 January 2008. Source: Lehman Brothers.
 
Nick Sheridan, fund manager, New Star European Value Fund

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 writing and should not be interpreted as investment advice.