Time to get picky as volatility grows

Investors eager to be in the eurozone will have to get used to high levels of market turbulence, say experts. They will also need to be selective as slower growth creates winners and losers.

Equity markets in the eurozone seem to have stabilised after a dreadful first quarter. But experts warn that fund managers who invest in them will have to get used to levels of volatility unheard of in the past few years.

Countries that for some time had been unmitigated sources of joy for investors have let them down in 2008. In Germany, the Dax index reached 6,200 points in March after finishing 2007 close to 8,000. Spain’s Ibex 35 plunged to below 12,500 points in February from almost 16,000 the month before. Although both have recovered a little since then, they remain far from last year’s levels. The picture is replicated around the region.

Eurozone equity markets have underperformed even though the region has largely avoided the economic slowdown seen in America. The horrible first quarter coincided with positive economic performance in the same period. Numbers released by Eurostat surprised many analysts, showing that the average rate of growth among the 27 countries of the eurozone reached 0.7% in the first three months of the year. Germany, the largest economy of the group, had a particularly good showing at 1.5%.

Such data indicates that the bad performance of eurozone markets is more related to the global credit crunch and the bad news coming from America than to the real economy of countries in the region. Many investors have embraced a less gloomy view of the market after equities hit bottom in March.

“The market has been driven by sentiment rather than anything else, and mostly by rising fear about global economic and financial conditions,” argues Maurice Gravier, head of active equity at Natixis Asset Management, in Paris. But he says the mood is changing and identifies the turning point: the announcement by UBS, a Swiss bank, of the writedown of $19 billion (£9.5 billion) in asset-backed securities in the first quarter.

“The next day, the UBS share opened down, but closed sharply up,” he recalls. He sees that as a sign that confidence in financial markets was being restored – a view later reinforced by successful rights issues by banks such as Banco Santander and RBS.

But global circumstances have played a part in the success of the real economy in the first quarter. Udo Rosendahl, the head of European equities at DWS in Frankfurt, points out that European companies have been able to take advantage of the boom in emerging markets to boost their sales abroad – an opinion substantiated by the strong performance of Germany, the region’s export powerhouse, in the first quarter.

“Economic sentiment from the export perspective is very strong, irrespective of the weak dollar,” he says. “This is not going to last for ever, of course, but people started to realise by the end of March that the environment is not as bad as feared and earnings won’t be that bad, either.”

There is a view, however, that first-quarter data showed that eurozone economies have reached a peak and a slowdown has begun. But Rosendahl says that in the near future, global economic conditions may help European equity markets, even if this forecast materialises.

“Emerging markets are still driving the global economy, and the financial crisis seems to be coming to an end”, he argues.”[America’s] Federal Reserve is stimulating the economy by lowering interest rates. So if the global economy doesn’t get into a recession, which is what we expect, equity markets have potential to rise during the remainder of the year.”

Gravier also says eurozone equity markets will remain on investors’ radars. “Equities in the region are not cheap when you look at sectors. Some of them are very expensive,” he says.

“But government bonds are probably overpriced relative to equities because there has been a flight for quality and yields are not great. Nobody wants to invest in real estate. Commodities have reached an all-time high. So we believe that equities are attractive in the long run.”

Proponents of a more pessimistic view are not difficult to find, either. “Eurozone equity markets have performed badly so far this year, and we believe perspectives for the remainder of the year are bad too,” says António Banda, director of investments at Bankinter Gestión de Activos, in Madrid.

Gravier adds a sceptical note to his predictions by admitting that “tactically speaking, we are not investing in eurozone equities today”.

Melchior Dechelette, head of European equities – thematic and fundamental at Paris-based Crédit Agricole Asset Management, expects eurozone equities to bring their usual rates of return of roughly 6% a year in the long term. But he forecasts that investors will have to keep their cool to achieve it. “Volatility will remain high for a long time and we have to live with that,” he says.

Those eager to invest in eurozone equities should look at sectors, rather than countries. Dechelette points out, for example, that Austria has been among the best performers of the year, but that is because its listed companies include many strong industrial, energy and utility companies. These are sectors particularly capable of taking advantage of high commodity prices and the hunger of emerging markets for infrastructure projects.

Construction, infrastructure, energy and consumer goods are widely seen as good bets in the future, while underperforming sectors include media, technology and telecommunications. But the challenge for fund managers does not stop at identifying such trends.

Rosendahl recommends that investors become more selective in 2008, and so does Gravier. In the boom years, just finding a good sector was often enough to make money with European equities, says Gravier, but investors will have to be much more picky. Slower economic growth, he says, will create winners and losers, and it will be competitive advantages such as innovation and strong brands that determine on which side a company will end up.