Follow the leader

European equities are expected to produce impressive performance again this year. But the improving eurozone economy will rely on Germany continuing to recover, and could be hit by rising interest rates. Helen Burnett reports.

The European market, and many funds that invest primarily in European stocks, has posted some positive performance numbers so far in 2006. However, positive returns are not new for this sector, which has done particularly well over the past couple of years.

Since the market’s most recent low point in March 2003, European markets have been climbing and have largely posted significant gains. According to Barclays Global Investors, European markets have risen 40% over the past year and a half. As at April 5, the German Dax index was up nearly 49% since October 2004, and has risen even more significantly since March 2003. France’s CAC 40 index is up 38% over the past 18 months alone.

Although Europe’s equity market has performed well over the past few years, many managers see this continuing through 2006, as they say trends this year are largely the same as they were in 2005. What does set things apart in 2006, however, is that there is evidence the eurozone economy is picking up, with domestic demand showing increased signs of recovery. But will a strengthening recovery have a positive effect on the market this year, or will it introduce additional risks?

Managers in the sector are mostly expecting, and welcoming, further recovery in the eurozone economy, but are not depending on it. “The market has so far been driven by factors not relating to any economic pick-up in Europe”, says Davina Curling, manager of the F&C European, European Prime and Eurotrust funds. Curling adds, however, that an economic pick-up this year could have an extremely positive effect on the market.

Rob Burnett, manager of the Neptune European Opportunities fund, says what has so far set this year apart from 2005 is the fact that the European consumer is beginning to show a modest recovery. “We do anticipate the German consumer, in particular, saving less and spending more as the year progresses,” he adds.

Burnett says that while he likes the fact that there are more positive numbers from a European consumer perspective, this only underpins the confidence he already has in the market.

The Europe ex UK sector is one of the top-five best-performing IMA sectors over the past three months, with an average return of 10.7% to April 7. The European Smaller Companies sector is the number one performer over the period, returning 18.8%, according to Trustnet.

In terms of the market, the MSCI Euro index has returned 12% so far this year, in dollar terms, compared with a 6.2% return for Japan and 3.9% for North America, as at April 1. According to Henderson Global Investors, the eurozone will offer prospective equity returns of 14%, in dollar terms, to March 2007, compared with 6% for America and 15% for Japan.

Global fund managers are also becoming increasingly bullish on European equities, according to recent survey data. The March Merrill Lynch global fund manager survey found that 43% of managers were holding a net overweight in eurozone equities, compared with 36% in both January and February.

One of the main boosts to the market in recent years has been the increase in merger and acquisitions activity in Europe, supported by low interest rates in the eurozone, making it easier to borrow. Many see this trend continuing this year, barring certain risks becoming reality, such as a significant rise in European Central Bank interest rates.

According to Tim Callaghan, manager of the Gartmore European Focus fund: “In addition to strong earnings momentum, M&A will be a prevalent feature for 2006. Scale and geography are no longer a hindrance to takeover and merger activity.”

He points to the recent approach for Arcelor by Mittal Steel, which he says “potentially opens floodgates for superscale takeovers in Europe, given traditional difficulties in buying strategic assets in many European countries”.

Burnett says there will be a notable cash inflow into the European market over the course of this year, through M&A activity as well as private equity and share buybacks.

Corporate reform in Germany is also beginning to pay dividends, according to Curling. She says that, as it was formerly hindered by a high cost base, corporate Germany began to restructure its balance sheets, the benefits of which were first seen in 2004 and 2005. In 2006, she adds, the market is again rewarding capital expenditure.

Burnett says the equity market returns seen in Europe over the past three years have been matched by earnings momentum. He sees the market continuing to grow based on this factor, as well as the fact that it is still relatively cheap.

While fund managers are still bullish on the prospects for the European economy, they are slightly less so than at the end of last year. According to March’s Merrill Lynch regional fund manager survey, 70% of managers specialising in Europe expect the European economy to get a little stronger over the next 12 months. This number is down slightly from February and, more significantly, from last November, when 80% of managers expected the European economy to improve slightly.

The eurozone economy went through a slowdown earlier this decade, which was attributed to various factors. These included global shocks, low business confidence and the unwinding of the post-reunification surge in construction in Germany, according to the International Monetary Fund.

GDP growth in Germany, the eurozone’s largest economy, fell from 3.2% in 2000 to 0.1% in 2002, and then into negative territory in 2003, according to the Organisation for Economic Co-operation and Development. The country’s labour productivity and multi-factor productivity fell over the same time period.

Similarly, GDP growth in the EU 15 countries fell from 3.9% in 2000 to only 1% in 2003, according to Eurostat. GDP in the eurozone began to pick up slightly in 2004 and the first half of last year, which the IMF attributes largely to stronger net export figures.

In contrast, numbers are expected to pick up more substantially this year, with GDP in the euro area expected to grow to 2.1%, reaching 2.2% next year, compared with 1.3% growth in 2005, says the OECD.

According to Philip Whyte, senior editor and economist with the Economist Intelligence Unit, the news coming out of Germany is key to the current optimism in the eurozone. Whyte says that while Germany has been successful on the export front, economic growth has remained sluggish for the past two to three years, as export growth was not feeding through to domestic demand. He adds, however, that there is now evidence that export growth is beginning to feed through to business investment.

Indeed, the Munich-based Ifo Institute for Economic Research’s business climate index reached 105.4 in March, the highest level seen since April 1991. Current optimism in the German market will also have a positive impact on the country’s trading partners, says Whyte.

Douglas Holtz-Eakin, director of the Maurice R Greenberg Center for Geoeconomic Studies at the Council on Foreign Relations in Washington, says what is different this year is business sentiment. He says that over the past couple of years there have been good months and bad months, but never a broad sense of the economy doing well.

However, many observers are keeping a close eye on consumer spending in the eurozone, particularly in Germany, which still seems to be lagging behind.

In the group’s most recent economic outlook, released late last year, Jean-Philippe Cotis, chief economist of the OECD, refers to the European economy as “progressively recovering”. The report says, however, that “the fledgling European expansion has been facilitated by low long-term interest rates, euro depreciation and buoyant export markets, although final domestic demand is still growing below trend”.

According to Eurostat, the volume of retail trade in the eurozone rose 1% in February compared with the same month last year, but fell 0.2% compared with January. Private final consumption expenditure in the eurozone was down 0.2% in the last quarter of 2005 compared with the third quarter. Germany in particular saw a fall in private consumption, down 0.6% in the last quarter compared with the third quarter.

Year on year, the picture looks slightly more positive, with the eurozone recording a rise of 0.6% in private consumption spending. Final domestic demand in Germany is also projected to climb 0.7% this year, up from a 0.1% fall in 2005.

In the interim assessment of OECD countries published last month, Cotis notes that in the larger eurozone economies there is a discrepancy between the weaker hard data and the stronger survey data. In Germany, says the report, activity stalled in late 2005 but “business confidence has reached very high levels, particularly in export-oriented sectors”. The report adds, however, that in areas centred on domestic demand, confidence is improving, but “less spectacularly”, and service sector confidence remains weak.

Morgan Stanley economist Eric Chaney recently noted that “in the end, evidence of the recovery in the heart of the euro area will have to come from domestic demand indicators”. He says this has not yet been seen.

Haydn Davies, chief economist with Barclays Global Investors, notes in a recent outlook that “the improvement in the fortunes of European companies has not been matched by a revival in consumer spending and industrial production is growing little fasterthan the 2% average annual rate at which it grew in the 1990s”.

Davies adds, however, that the recovery continues, and with many European companies planning to hire more employees this year, consumer spending will likely continue to recover gradually. He also points to a pick-up in manufacturing and construction orders that is already under way.

The OECD report says that domestic demand should soon start to see a more significant pick-up as the year progresses. “The strong external side should feed through to euro area domestic demand and a rebound can be expected in the first half of 2006,” it says.

In contrast to Germany, Whyte says GDP growth in France has been held up by domestic demand, with consumer spending boosted by a fall in the savings ratio. Indeed, France’s private consumption expenditure grew by 2.1% in the fourth quarter of 2005, compared with the same quarter in 2004.

In addition to healthy spending in France – and Germany continuing to restructure and do well in the export sector – another main driver of the European economy has been the Spanish real estate boom. This is the view of Charles Dumas, head of the world service at Lombard Street Research.

However, in spite of the expected rebound, the OECD cautions that “further structural reforms are needed to improve the euro area’s medium-term economic performance and resilience to shocks”.

“If you assume a benign external environment, then a recovery in the euro area should be relatively well supported,” says Whyte.

With respect to the recovery of the eurozone economy, one of the main concerns for markets remains inflation and the future path of interest rates. Last month, the European Central Bank raised interest rates to 2.5%. This was the second rate rise for the bank in three months, having previously left rates on hold since June 2003.

The possibility of further significant hikes in eurozone interest rates remains a key issue for many managers and economists, given the current recovery environment. While some are saying that a considerable hike in interest rates is not a current threat, others are arguing that such a move still poses a risk to the market.

According to Holtz-Eakin, the ECB is facing a situation parallel to that of the US Federal Reserve. He says both believe growth will be slower in future than it is at the moment and are looking to make a move in advance before the slowdown happens. “Both are facing tough policy questions at the moment,” he warns.

Whyte says he is expecting interest rates to reach 3-3.25% this year and continue to rise into 2007. He adds, however, that monetary policy in the eurozone is already highly accommodative, as broad money growth is strong.

Dumas recently noted that, “it is not surprising that some people fear the ECB will choke off the recovery with major interest rate hikes soon. But this seems unlikely”.

In its latest economic outlook, the OECD cautions that, within the eurozone, “monetary tightening should wait until the recovery gathers enough momentum and becomes more resilient, which may take a few more quarters”.

According to Curling, there are two main risks to market performance this year: disappointing corporate earnings and a massive interest rate rise. She says it has been the low level of interest rates that has allowed for the amount of M&A activity in Europe and has made equity markets look attractive. A significant interest rate rise would have a negative effect, but Curling says she is not expecting that to happen.

“A change to the currently benign backdrop provided by interest rates right across the duration spectrum could prove the biggest barrier to further progress by European equity markets,” says Tim Callaghan, manager of the Gartmore European Focus fund. “Strong cashflows and cheap access to finance for both corporates and financial buyers firmly underpins markets at the moment.”

In addition to the path of European interest rates, global growth patterns, especially American interest rates, are being watched by European equity managers. According to Chris Garsten of 2CG, investment adviser to the Close Finsbury Continental European Equity fund, Europe also faces the risk of a slowdown in the US economy, given that American interest rates are rising.

Burnett says he is watching the direction of the Fed and hopes that further increases in interest rates around the world are reflective and steady in nature.

Dumas does not see any major threats to the recovery in the near term, including ECB rates, as the bank seems to have a pre-emptive eye on thebubble. He says that one of the main problems facing the liveliness of the recovery would be weakness in the rest of the world, specifically in America and China. However, he adds that most exports in Europe are made within the eurozone as well as to Central and Eastern Europe, which lessens the region’s vulnerability. Within Europe, he says, potential problems could include a housing bubble in Spain.

Although concerns over the possibility that rising ECB or global interest rates might put the brakes on the European recovery or M&A are being voiced, many still see a sharp hike in rates as an unlikely scenario. However, others say that over the short term, the European market looks to be continuing as it has done for the past few years.

According to Davies from BGI: “The combination of an upbeat economic climate and buoyant liquidity should keep European equity markets outperforming for now.”

European small caps
European small caps are doing especially well in 2006 as the sector was ranked first over the first three months of the year and third out of all sectors in terms of performance over the year to April 7, slightly behind Japan, according to Trustnet. In terms of retail sales, the European Smaller Companies sector saw inflows of nearly 47m in February, according to the Investment Managers Association. Over the past three years to April 6, funds in the sector have returned an average of 188.8%, compared with an average return of 109.7% in the Europe excluding UK sector, according to Trustnet.

Phil Dicken, manager of the Threadneedle Pan European Smaller Companies fund, says three main factors have led to the ongoing outperformance of small caps in Europe. The first is historically low interest rates. “Interest rates are going up but they are still at historically low levels,” he says.

Second, companies throughout the eurozone have been restructuring their balance sheets, a move not driven by government or policy, he says. There has also been significant merger and acquisitions activity in the sector, as low interest rates have made it easy to borrow. Other drivers for the European smaller companies sector include growing demand from emerging markets, Dicken says.

In spite of this, Dicken says there are still risks to small-cap performance in Europe this year, including valuations and a potential stifling of the recovery if inflation rises higher than expected. He adds that any worries over global growth could also lead to money leaving the sector in favour of the large-cap area, which is considered safer. Dicken says there has been a re-rating of European small-cap stocks over the past couple of years and that small caps are now trading at a premium to their large-cap counterparts. This reflects the high level of growth seen in smaller companies, he says.

Iain McNaught, manager of the Schroder European Smaller Companies fund, says that although there are risks in the European market at the moment, there are always areas in the market that are not under so much threat.

McNaught is bullish on the oil services sector within the European small-cap space because of ongoing demand, which is higher than supply for such products at the moment. He also continues to look out for the theme of demand exceeding supply, as a sign of good pricing power. Another example of this in Europe is the aerospace sector, he says, where European producers are benefiting from the demand for composite materials, which are now being used in the construction of new aircraft.

Davina Curling of F&C says that many strategists were saying last year that the outperformance of small caps in the sector might be nearing an end, with performance shifting instead to large caps. She adds, however, that she has not yet seen a market cap shift in performance terms in the European market.