The interest rate cut belatedly implemented by the European Central Bank (ECB) at the beginning of April barely caused a flutter on the markets, as investors focus their attention on the German and US economies.
“The market did not react that much to the interest rate cut, because it was more or less expected,” says Sharon Coombes, European equities strategist at HSBC Securities in London.
Overall signs point to an improving global economy, and the shift in investor interest from stable growth stocks to cyclicals means that they are expecting a global economic upswing. There are indications that even Europe is moving into a more positive position. Germany and Italy remain weak markets, said Coombes, but “Spain is booming and France is very strong.” Although Germany and Italy together account for around 50% of the euro-zone GDP, Germany and France have similar market capitalisations, and France’s relative strength helps keeps the euro-zone as a whole on a more even keel.
What is keeping the attention of analysts is the state of the US economy. The US market continues to boom, with the Dow Jones average at all-time highs. The biggest risk for equity investors now is the ultimate correction in US values. “There is a risk that the US market will correct itself by 10–15%,” says Dietmar Becker, chief investment officer at Dresdner Investment Group in Germany. “If this happens,then the European market will follow even worse.”
Coombes agrees that the risk is there. “The biggest risk is if the US economy keeps booming and the Fed starts worrying about inflation and raises interest rates. There will be a big knock-on effect.” But, she adds, “this is not our central view of what would happen. People forecast a downturn in the US every year and it never happens.”
The underperformance in Germany is also a concern. This market had been suffering particularly from the recent rally in stable growth stocks, which are not well represented in the German market. However, Dresdner’s Becker pointed out that the rally in cyclical stocks, in evidence for the past four to six weeks, should benefit the German stock market.
Changes in the German tax law also signal the possibility for positive structural change. Becker noted in particular the fact that share buy-backs are now possible: companies can buy back up to 10% of their outstanding stock each year, and this represents an opportunity for many highly liquid companies. “This will have a significant effect on performance,” Becker says, “and this will have a positive, long-term effect on the German stock market.”
Other positive structural changes will also benefit the euroland equity markets in the long term. These include increased flows of funds into equities throughout the euro-zone and the continuing “merger mania,” as companies manoeuvre to become large enough to compete on the pan-European stage.
However, these trends also have their downside, warns Mikael Randel, managing director of Carnegie in Denmark. The Danish market, like other small countries, is dominated by a few very big institutions. “They set the tone, and they are all redefining their market not only as the Euro-zone, but as Europe,” said Randel. “There is a lot of local selling, and this is having a continuing negative effect in a small country like Denmark. They are all buying large.” This trend, evident in other small European countries, is increasing the gulf in valuation between small and large shares.
“A large and reasonably aggressive community of individual and small investors might see the opportunities presented by small companies,” said Randel, “ and they could counteract that trend.” He points to the example of Sweden, where there is a large population of well-educated small investors. However, this is not the case in Denmark, which is a big disadvantage. The only small companies that will thrive under the current scenario are those in the “hot” sectors, such as the internet, “because they will not stay small for long”.
The German government has been taking steps to encourage investment in small to medium-cap stocks. A recent change in the tax law has abolished capital gains tax on profits from shareholding, as long as the stock has been held for one year (dividends are still taxable income).
In addition, new indices for small and medium caps are being launched, which in combination with quarterly reporting will make the small to medium-cap market more transparent, notes Dresdner’s Becker.