Pulled in two directions
The prospect of rising interest rates in the US and the risk of a rapid slowdown in the economy in China has cast a shadow over European equity markets.
Financial markets in general have been driven by fears of a reduction in liquidity and an increase in risk aversion. This is as bad for equities as it is for other asset classes, and most investment houses are advocating a cautious approach to Euro-zone equity investment over next few months.
European strategists believe that the outlook will improve only when it becomes clearer where US a interest rates are headed and whether the Chinese economy is in for a hard landing.
Against the uncertain global backdrop, the Euro-zone economy looks surprisingly buoyant. Growth in the Euro-zone area has been stronger than expected. The Euro-zone real GDP increased by 0.6% in the first quarter of this year, an annual rate of 2.4%. This was the strongest growth since the same period three years ago, and followed news that GDP has strengthened in Germany, France and Italy. The ECB left Euro-zone rates unchanged at 2%
The result of the discrepancy between Euro-zone growth and global uncertainty means that Euro-zone equity markets could develop into a tug-of-war situation where earnings growth push markets upwards while fears of higher interest rates in the US hold markets back.
Ben Funnell and Teun Draaisma, co-heads of European equity strategy. at Morgan Stanley in London, see a step change in the investment climate: “The last 12 months were about growth expectations rising, interest rates remaining low, and as a result, risk appetite increasing. As we look at it, the next six to 12 months could be about growth expectations cooling, interest rates rising, and risk appetite decreasing as a result.”
Funnell and Draaisma cite a number of reasons why expectations of growth might cool. The first is the sharp rise in the price of oil. The OECD has estimated that the initial impact of a 50% increase in the oil price would result in a loss 0.25% of GDP in the US after a year, and almost double that loss in the Euro-zone.
Other factors include the rally in the US dollar, China, interest rates, and the move from recovery to mid-cycle growth.
This is not all bad news, they say. “The good news is that these are indicators of market direction, either sideways or down, while valuation, which is an indicator of magnitude, is still supportive. ”
Yet they remain defensive in their sector allocation. “In our model portfolio, we are underweight and would still sell China plays, commodities, emerging market exposure, and risk equities such as high-beta financials, techs and cyclicals. We are overweight and would buy energy, staples and pharmaceuticals.”
Another factor likely to have an impact on Euro-zone equity markets in the longer term is the accession of 10 new members states to the European Union on 1 May. Erik Nielsen, director of EMEA economic research at Goldman Sachs economic Research group, has assessed the impact of the expansion, and concludes that the inclusion of 10 new economies will provide momentum to the underperforming EU. “The addition to potential growth in the existing EU could be about 0.4% per year during the first couple of years, of which almost all would come from the smooth functioning of the single market through the enlarged EU.”
Of the existing EU countries, those with the greatest trade with central Europe – notably, Sweden and Germany – will be the biggest beneficiaries. However, he suggests that the real winners will be the accession countries: “The bottom line is that the potential growth effect is substantial for the newcomers but modest for the existing EU countries.”
Average productivity rates of 10% or more in recent years and a real appreciation of exchange rates will narrow the gap between the accession countries and the existing EU economies. In theory this means an attractive investment opportunity for equity investors.
Yet Nielsen warns that the central European region’s equity market remains thin and that most of the high productivity growth is generated by foreign owned companies. He suggests that investors would be better advised to invest in Euro-zone companies that are most exposed to the region’s cheap but skilled workforce.