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Consumers hold the key

After three years of significant underperformance, Euro-zone equity markets outperformed the US, UK and Japan markets in 2003 as investors switched out of bonds and back into equities. The question is whether this is likely to continue in 2004.
Some analysts suspect that the economic and financial recovery expected this year has already been fully priced into the equity market. Yet European markets still have some way to go to reach their previous levels. Even after the recovery in prices during 2003, French and German equity markets are still at less than half the peak levels they reached in 2000. So European equity markets still offer some value to investors.
Stephen White, head of Continental European equities at F & C in London, is optimistic that the demand for equities will be sustained in 2004: “After two years of heavy selling of equities by institutions, mostly insurers, corporates are now buying back their own shares on an ongoing basis. Recent rights issues were successfully absorbed by the market, indicating that demand is high given attractive opportunities.”
Some institutional investors are so optimistic about the prospects for 2004 that they have increased equities in their asset allocation, he says. “Our outlook for continental European equities for 2004 is therefore positive, and the economic upturn should be very supportive for stocks.”
If the improvement in the economic outlook expected in 2004 has already been reflected in equity valuations, this will limit European markets’ progress this year, he concedes. However, even under these circumstances European valuations still look good. “The price earnings ratio for 2003 stands at 15.7, with a
dividend yield of 2.6%. Based on earnings expectations for 2004, the P/E ratio is just 13.6, which represents good value compared with other major stock markets.”
For investors, this means sticking with cyclicals for a while longer. The cyclical sectors have outperformed over the past nine months, and asset managers are poised to switch into defensives. However, White advises that, so long as the recovery scenario continues, investors should continue to focus on the sectors most likely to benefit from a recovery. A rise in interest rates would mean a switch into defensives, he adds.
Both European and UK interest rates are expected to rise in the second half of the year. So far, the European Central Bank (ECB) has left rates at 2%, which has not surprised the market. White surmises that the new president of the ECB, Jean-Claude Trichet, is biding his time: “In the long term, with economic growth accelerating, there is a high likelihood of interest rates rising. We expect a gradual increase of 125 basis points in the second half of 2004, in accordance with the economic upturn. This would lead from a relaxed ECB monetary policy to a more neutral stance.”
However, some analysts warn that the economy and the equity markets do not always move in tandem. Jaap van Duijn, chef strategist at Robeco in Rotterdam, points out. “The recovery of 2004 was already anticipated in 2003 and as a result, price
earnings ratios have already increased in several sectors. The prospect of something happening is often better than its actual occurrence.”
Van Duijn says that Europe is showing its usual pattern of a six-month delayed reaction to the recovery of the US economy. “The European eco-nomies should have seen the worst by now. Growth here is more likely to be better than expected, rather than worse.
He expects the economic recovery to continue. “Inflation is low for the time being, due to rising productivity and wage restraint. Corporate profits will increase further, and monetary tightening is not expected for quite a while yet.”
In terms of valuation, European equities are attractive, he says. Producer stocks have become more attractive than consumer and consumer discretionary stocks. However, even consumer stocks such as IT are showing.
Notably, an unexpectedly strong trading statement from Nokia, a bellwether IT company in Europe, has lifted the whole IT sector. Raiffeisen equity research team in Vienna says Nokia’s trading statement is not only good news for the IT and telecom companies but for corporate earnings growth in general in 2004. Figures indicate that the recovery in capital and technology spending is on track, they say.
A further strengthening euro remains a threat to Euro-zone equities. Eric Chaney and Joachim Fels, co-heads of Morgan Stanley’s euro area economics team in Paris and London, warn that a further steep rise of the euro is the main risk factor to a positive view of the first quarter of 2004: “A lasting overshoot of the euro against the US dollar and the yen would probably be fatal to our recovery scenario, and we would not exclude a ‘triple dip”.
However, the consumer is the key to the future of equity markets. Chaney and Fels say this year’s recovery will be demand -driven. They point out that since the third quarter of 2003, data has been improving, notably the German ifo index of business confidence, which has risen for eight months in a row.
They expect consumer spend-ing, which increased 1.3%
in 2003, to accelerate further to 2% in 2004, as a result of stable labour market conditions, stronger purchasing power stemming from lower inflation and income tax cuts in Germany and France worth E17bn, or 0.3% of GDP.
Consumers could be the trump card of the Euro-zone, they conclude. “As they get more used to euro-denominated price tags, and realise that inflation is declining and that pension reforms are making their future less uncertain, they could well produce a surprise by breaking open their piggy banks.”

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