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Cart before the horse?

The Euro-zone equity markets rally that began last March has been driven by the market’s expectation of an economic recovery. Now the signs of a genuine recovery seem to justify the market’s optimism. The question is now no longer whether equity markets have fully recovered but what happens next.
Whether the recovery is sustainable will depend largely on whether companies can continue to generate real profits, says Monika Rosen, head of research at Bank Austria Creditanstalt in Vienna. “What has happened so far has been a text book case of equities anticipating economic development. In this case the equity markets turned about six months before the economy did. Now the question is how much of that is in the prices and how much further will it have to go?”
This will depend on companies building profits other than through cost reduction. “We will have to see further improvement in profits. So far a lot of this has come from cost-cutting and restructuring. In future, it will have to come from top-line growth, and I think the evidence for that is to some extent still a bit patchy. There have been some improvements but they are not 100% across all industries.”
It will have to be a self-sustained recovery, especially in Europe where governments are trying to push through social reforms and trying to exercise a certain amount of budgetary control. That seems to be giving consumers some pause.
Companies are still understandably uncertain about how permanent the economic recovery is likely to be, Rosen says. “The general line of thought from companies seems to be that half of their customers are spending and half are waiting. You don’t really get an unambiguous picture of everything being on a solid footing again. But then that is not really to be expected in the early part of a recovery.”
There are certain reasons to be a bit cautious after the strong rally this year. However it is little premature to write the recovery off.
The Euro-zone equity market has no doubts, and continues to bet on the economic recovery, equity markets that have fallen lowest have climbed back. Germany’s DAX has surged 68% since dropping to a seven year low in March. “They are being helped by very low interest rates, by restructuring, all of those factors together are helping to underpin the markets.
Meanwhile, confidence in a cyclical recovery has continued to favour cyclicals she says. “It has been the year of cyclicals. Since the recovery started in March it has definitely been the more cyclical plays like technology that have out performed the market. Defensives, after three excellent years, have lagged.
“Personally, I don’t think there will be a change in the scenario unless there is first some consolidation. If we get a certain consolidation then defensives could take the lead again. But for the moment I have a feeling that as long as the market is betting on this cyclical recovery it will prefer cyclical stocks.”
Various economic straws in the wind seem to support this optimism about the recovery. The ZEW Indicator of Economic Sentiment for Germany has increased again in November after having consolidated in the previous month. The indicator now stands at 67.2 points compared with 60.3 points in October.
The 308 analysts interviewed by the ZEW for the indicator say they were impressed by the surprisingly strong increase in new orders in September. Business confidence in Europe’s largest economy and bellwether, Germany, has been rising for six consecutive months.
Haydn Davies, chief economist at Barclays Global Investors in London, says that German businesses are at last beginning to report stronger orders and there are signs that a recovery is really getting underway. However, he adds that the recovery remains patchy and is “nothing to get too excited about”.
The key issue for Euro-zone markets now, he says, is how much of the recovery is coming from within the region’s borders and how much is merely being poached from overseas, and from the US in particular.
In the current climate, European equity markets offer good value, he suggests, particularly markets such as Switzerland and the Netherlands, which have the heaviest exposure to markets overseas. European equities also offer marginally better value than bonds, he says, thanks to the euro.
“The euro is now less of a drag on the region’s equity markets than it used to be, but supported by the relatively high interest-rate environment, the currency is set to advance again,” he predicts.
Whether a real economic recovery in the Euro-zone will drive up equity prices further is uncertain, however. The strong rally that markets have enjoyed since March means that investors have already anticipated a revival. This has been a year of risk repricing, according to Nathalie Monnoyeur and Delphine Georges, equity market strategists at Credit Agricole Asset Management (CA-AM).
Monnoyeur and Georges point out that in the European equity markets, risky stocks – those with a high beta – have outperformed their low-beta counterparts by 45% since March. As a result, the risk premium on equity markets has fallen, driven by expectations of a cyclical turnaround and improved earnings visibility.
The markets are now far more sensitive to risk factors, they say. The CA-AM risk aversion index is rising, and investors are once again homing in on fundamentals. In Europe, ‘high-quality’ securities, characterised by improving earnings momentum, out-performed in September for the first time since the March rally.
This suggests that equity investors believe the recovery is real and are prepared to back companies that promise real top-line growth.

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