Playing safe in Europe

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The question that has been puzzling Euro-zone equity strategists is why, when the sun has been shining so brightly in Europe, are the European equity markets not making hay?
Yet in spite of this, European equity investors have chosen to play safe. Axel Botte, investment strategist at AXA Investment Managers in Paris, says the caution is surprising. “So far this year European equities have been trading within a narrow range of 7%. Remarkably the European equity market has partly ignored the positive surprises regarding economic growth and corporate earnings in the first half of 2004,” he says.
The equity market recovery, which began in May 2003, has flattened as a result. The MSCI Europe provided a return of 5.2% in the year to date to 30 September. This compares with a bouncing 20% return from MSCI Eastern Europe. “The 5% year to date performance of European equities has somewhat disappointed expectations, given the revival of economic growth,” says Botte.
The most distinctive feature of the recovery has been the fall in volatility, he says. “We think the sustained fall in volatility has more to do with the disappearance of large valuation discounts within the European markets.”
However, Botte says there are still some relative valuation opportunities in the market, notably financials, telecommunications and healthcare. At the other end of the scale, technology and energy stocks look expensive.
There is little to chose between styles at the moment, he says. “ We estimate that the risk premium on value stocks is only 5 basis points higher than that on growth stocks. Such a marginal difference provides little incentive to discriminate between the two styles.”
Teun Draaisma and Ben Funnell, Euro-zone strategists at Morgan Stanley in London, believe that Euro-zone equity markets are ready to shake off their caution, given the right encouragement. “The vast majority of money managers are without conviction, close to the benchmark and underperforming year to date. This is one of the reasons we expect a break-out of the tight trading range that has existed this year.”
Like most analysts they have pinned their hopes of a break-out on two key developments – a halt to the rise in oil prices and better employment figures in the US.
The Euro-zone is a net importer of oil, so the 70% rise in euro-denominated crude prices since the beginning of the year and the 11% increase in energy prices will hit both wages and profits.
Equity analysts had expected oil prices to peak in October and drop back slightly towards the end of the year. Similarly the were keen expectations that the US payroll data for September, a measure of job creation in the US, would show that 150,000 new jobs had been created
In the event, both indicators have disappointed. The oil price has continued to rise, and the number of new jobs created was below 100,000. This has had the effect
of strengthening the euro against the dollar.
One factor which has yet to have an impact on the Euro-zone equity markets is of US presidential elections. Most analysts believe that the market has yet to factor in the election. Natalie Monnoyeur, equity strategist at Credit Agricole Asset Management in Paris, says: “The US presidential campaign has so far had little impact on markets even though the latest jobs data, being mediocre, will probably give a lift to the Democrat candidate.”
However, some analysts are focusing on particular sectors of the markets. Fraser Chalmers, head of European equities at Standard Life Investments in Edinburgh says the result of the US elections could have a significant impact on stocks in the pharmaceuticals sector.
“In the US the two parties hold opposing views on how public healthcare should change. Bush proposes a system of refundable tax credits that would enable low earners to buy health insurance,” he says.

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