Rebuilding and repair
Finance ministers and central bankers of the Group of Seven industrialised nations met recently in Washington to consider what the world would look like economically after the war in Iraq. They concluded that there was no longer any justification for a low growth expectations in either Europe or the US.
In spite of this, European equity analysts remain sceptical about the prospects of economic growth in Europe The prevailing view is that European equities have been lifted by a bear market rally following the fall of Baghdad. Prices will revert to their normal level and the European economy will revert to its customary pattern of torpid growth.
Laurent Imbert, head of European and Emerging Equity at CDC-IXIS Asset Management in Paris says: “The market consensus is that the European markets are expected to go 10% to 15% higher. Most of the market thinks we will reach this point in the near future and thereafter a lot of institutional investors will probably sell some of their positions and therefore the market will fall back.”
However, he says that one scenario the market is not considering currently is that markets will continue to rise. “Nobody is taking into account the probability of higher markets before the year ends. What will happen if the markets go up 20%? Will institutions stay away from equities or not? Will they feel that it’s an opportunity to sell or will they feel that it’s a risk to be under-invested on the equity side? I don’t know. But if you want to out-perform that’s the scenario you have to work on.”
Imbert suggests that talk of a bear market rally ignores what is happening in Europe at the corporate level. “The war premium is no longer in the market. The most important point from a long term point of view is the restructuring of European companies. If the macro economic outlook continues to improve companies that have already restructured their balance sheets will show better results at the end of the year. The general profitability of these companies will increase dramatically. There is no pressure on salaries from employees, interest rates are historically low, inflation is low. This means that if there is any more profit it will go directly to the shareholder.”
The environment for mergers and acquisitions has also improved, Imbert says. The improvement was signalled last October when the EU Court of Justice’s overruled the European Commission’s decision to block Schneider Electric’s acquisition of Legrand. “Deals that formerly looked impossible will be possible now,” he says. “The sectors that will probably benefit from this are pharmaceuticals, retail and banking.”
Germany, where corporate restructuring has meant financial restructuring, faces problems of its own, principally in a E35bn convertible bond issue. “Probably for them the most important difficulty is in the near future. Three or four years ago it was very fashionable to print convertible bonds on the cross-participation of all the German financials. Before the end of this year one third of all these convertibles will be out of the money and will have to be paid in cash. In addition, institutions will end up with shares they hoped to offload.” The pressure this will put on German financial institutions means that it is too soon to have a bet on Germany, Imbert suggests.
One sign of improving health of Euro-zone companies is the steady reduction in corporate debt. The fact that companies are increasing their loan duration to take advantage of longer term interest rates suggests that debt consolidation is now underway, says the Commerzbank Securities pan European equities team in London.
However, it says the process is taking longer than it should, largely because of the inflexible nature of the Euro-zone area economy. “Only now, after more than two years of stagnant growth are firms starting to reduce their headcount. In the case of Germany, the works council remains a major obstacle to labour market restructuring, which, in turn, hampers balance sheet restructuring.
Until there is proper restructuring, Commerzbank strategists remain sceptical of the predicted V-shaped post-war recovery. “Balance sheets still need to be repaired, irrespective of the events of war, and that is going to take longer. Anyone hoping for a repeat of the late 1990s is going to be disappointed – it is going to be a slow economic haul from here on in.”
One unexpected engine of growth for the European equity markets could be the retail investor. European portfolio strategists at Citigroup Smith Barney (CSB) suggest that the retail investor can have an important impact, and can drive markets up or down to extreme levels.
Retail investors are currently convalescing from their bruising experiences in a three year bear market, and are reluctant to go back for more. But while cheap equity prices may not tempt them into the markets, new products will – notably guaranteed capital products. Since last year, the leading Spanish banks have had great success selling capital guaranteed equity funds to retail investors who do not want their fingers burnt again. Data from Inverco shows that, in spite of 25 months of equity fund outflows, retail investors have bought E1.8bn of capital guaranteed equity funds in the past two months – the largest inflow since 2000.
This inflow could grow much larger. Currently, Santander bank is launching a guaranteed product linked to the performance of a basket of funds which is expected to suck E5bn into the equity markets. CSB strategists suggest there may be a lesson here; that structured products from financial institutions can do more to build investor confidence than any evidence of improving equity markets.