Equities can rise despite slowdown

Eurozone equities have bounced back from the market correction, driven by healthy earnings and a glut of mergers and acquisitions. This should continue no matter what happens in the US.

As we head towards the end of 2006, eurozone markets are touching levels that were last seen five years ago. The key drivers that have helped European shares achieve gains in recent months, principally a strong flow of healthy earnings news and a fresh round of M&A activity, are still in place. This has encouraged a general feeling of optimism about what the next few months will bring.

At the end of June, few commentators could have predicted the vigour with which markets recovered from the losses of the previous two months. Despite fears that volatility would return, late August saw a strong rally. Share prices were buoyed by positive macroeconomic news, including a drop in the oil price, helped by a ceasefire in Lebanon and encouraging inflation data, which allowed the Federal Reserve to keep American interest rates on hold. Since then, markets have scarcely looked back, surprising many with their resilience.

Nonetheless, the possibility of volatility swings on the back of fresh economic newsflow remains a concern.

Investors have closely scrutinised American data in recent months looking for solid evidence that the economy is facing a soft landing, rather than heading for a crash. On the negative side, the long-term bond yield plummeted and the housing market began to look increasingly weak. However, more recently inflation has appeared to be in check, interest rate cuts have become a possibility for 2007, and the American consumer sector has been buoyed by lower gasoline prices and a strong stockmarket.

Confidence has increased steadily over the past few months and, for now, the soft-landing scenario has the upper hand. European equities are rising almost twice as fast as usual in the fourth quarter, typically the best period of the year.

While we remain confident on the outlook for European companies in the medium term, it is worth pointing out that the current bullish environment could be fragile, and the risk of a short-term pullback in the market should not be discarded. There is still a risk that American data could spook the market in the next few weeks and that the hard-landing scenario may not have been completely killed off yet.

The high level of merger and acquisition activity has been one of the positive factors that has helped European share prices overcome concerns about America and drive markets to multi-year highs. Towards the end of August, the merger of Banca Intesa and San Paolo, the second and third-largest Italian banks, triggered speculation about the possibility of further consolidation in the industry. The pharmaceuticals sector also saw some frantic activity, with three takeovers among mid-cap groups.

An increase in hostile or international takeovers has encouraged some European governments to sponsor the creation of “national champions” as a form of protectionism. Spain provided a clear example of this in September as Acciona, a Spanish construction group, countered an approach from Germany’s E.ON for Endesa, a power company. And ACS, another white knight stemming from the construction sector, bid for a stake in number two utility Iberdrola. Despite the positive impact these events had on the Ibex index, there is a risk that this type of action could put a stranglehold on the intentions of would-be buyers across Europe.

Looking forward, however, we are confident that the economic forces behind Europe’s consolidation are great enough to overcome this type of government intervention. Merger and acquisition activity remains in full swing in Europe and should continue to be a powerful driver of equity gains in the months ahead, with European corporate takeovers on course to eclipse the American market for the first time in four years.

Positive corporate earnings news has been another major factor boosting theshare prices of European companies recently. The third-quarter reporting season saw plenty of positive surprises, with more companies reporting earnings that exceeded estimates than fell below expectations. The potential for earnings growth remains a source of optimism for us, as estimates continue to be raised, the tone of most corporate management teams is confident and, more importantly, the price/earnings ratio of European stocks is still compelling.

Although the eurozone’s economy is on track to expand at the fastest pace in six years in 2006, recent data from France and Germany has been disappointing. In October, the European Central Bank increased rates for the fifth time in 10 months, and rates are likely to reach 3.5% by the end of the year. In an environment of higher interest rates and lower American growth, the outlook is for slower economic growth.

This will have implications for European companies, but slower growth does not necessarily mean investors should expect lower returns. What we are now seeing is the performance of major stock indices often diverging from their underlying economies. Looking forward, high-growth areas such as Asia look likely to offset a slowdown in other parts of the world, such as Europe.