We must all hang together or, most assuredly, we will all hang separately. This is the current message from the Euro-zone equity markets, rattled by fears of a war in Iraq and its consequences for the US economy.
The high degree of correlation between the European and US markets means that what happens to equities in the Euro-zone is strongly linked to what happens to equities in the US. “All you need to know to guess which direction the European equity market is going is to watch the US market open each day and see Europe following slavishly,” says Michael Schoeck, head of global active equities at State Street Global Advisors in Boston. “Europe is not the driver – Europe is following.”
Schoeck says the correlations between the US and European equity markets have been increasing for the past three years and will remain at a high level well into 2003. “Over the next three to six months it’s unlikely that Europe is going to be able to outpace the US. Europe will not be able to decouple, certainly with a strong common currency.”
Euro-zone equities continue to struggle to keep their head above water. Deutsche Bank’s equity research team in London reports that, in local currency terms, Europe ex-UK return of –5.3% was an improvement on December. This compared with a world return of –3.6%. However, the strength of the euro meant that the returns were broadly similar in euro terms. Within Europe, Austria (0.5%) and Ireland (0.1%) just managed to achieve positive results. Finland continues to be hardest hit (12.9%).
Correlations between countries within Europe are also increasing, says SSGA’s Schoek. The performance of German equities may be partly related to the economic weakness in Germany, he concedes. But this is almost as much as a problem for the rest of Europe as it is for Germany.
“We are really talking about a European market where the major stocks that really drive the indices are very highly correlated by industry across Europe. The heavyweights in Germany – the insurers, the banks, the telecoms companies – are all pan-European or global stocks.”
Strategists at Credit Agricole Asset Management (CAAM) in Paris suggest that that the Euro-zone’s cycle is likely to remain highly synchronised with the US business cycle for the time being. The CAAM team is sticking to its prediction of a moderate recovery in Europe and the US, with a return to trend growth in the second half of the year.
Catherine Lee-Saunders, Euroland strategist at CAAM says the European Central Bank’s 0.5% interest rate cut the rate cut has probably cleared the deck for at least the first half of 2003. “The risks to growth are still weighted on the downside. This could, if supplanted by a further sizeable rise in the euro, produce more easing next year. But the ECB would probably be happier if core inflation were to fall comfortably below 2% next year – a tough hurdle. For now, the costs of prolonged sub-par growth dominate the ECB’s thinking, and not current inflation rates.”
The outlook for the Eurozone economy remains gloomy, the ING Investment Management’s strategy team in the Hague, says : “Present levels of both confidence and activity indicators tell the story of a well-below potential growth for the near future. The effective euro appreciation since the last ECB rate cut is also partly responsible for this lack of faith in future growth.”
Market analysis provides no strong signal for equities at this stage, they say. “Our central scenario calls for only muted economic growth and a moderate corporate profit growth. In this context, equities might recover, but the downside risks remain significant. Taking the risks around a US-Iraq conflict into account, a wait-and-see attitude seems reasonable for the moment.”
The correlation of equity markets means that any growth, wherever it occurs worldwide, is likely to give a life to Euro-zone equities. Fraser Chalmers, head of European equities at Standard Life Investments says although the Euro-zone economy lags the rest of the world, some modest global growth could support European equity markets.
Chalmers believes that the current economic environment, in which policy making authorities are vigorously pursuing reflation policies against an already stimulative monetary background, favours cyclicals. “We are heavy in cyclical sectors that will benefit from moderate economic growth. Conversely we remain lighter in the defensive sectors such as pharmaceuticals and food where valuations appear comparatively stretched.”
Zafar Ahmadullah manager of Schroder Investment Management’s euro equities fund in Paris is optimistic about prospects in the Euro-zone: “Inflation within the euro zone remains under control and we would not be surprised to see a further fall in rates, which would be likely to provide an additional spur to growth.
Ahmadullah favours sectors that are likely to benefit from a recovery in economic growth – in particular cyclical consumer products or luxury goods which have considerable freedom in terms of pricing.
“We remain under-weight in information technology because, first because this sector continues to suffer from the effects of the bursting of the IT bubble at the end of the 1990s and second because the signs that consumer demand has resumed remain very weak. We also remain very cautious with respect to the energy sector, due to uncertainties about oil prices.”
Markets dislike uncertainty. SsgA’s Shoeck says “A lot of the market’s unforecastable right now, since so much depends on geopolitical events. It’s tough to recall a environment where there were so many unquantifiable risks.

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