December saw rate cuts across the euro-zone, in what some commentators have dubbed the European Central Bank's first monetary policy move. The credit easing may have focused minds on transition to the single currency, but European markets cannot shake off concerns about a weak outlook for economic growth.

In Germany, key data have added weight to the view that corporate earnings will fall short of expectations. New orders for German manufacturing industry fell 2.5% in October - further than analysts had expected. James Cornish, European equity markets strategist at BT Alex Brown, predicts German GDP growth could be as low as 1.5% next year. Clearly, company earnings are not going to be growing by 10-15% next year - they'll be lucky if they grow 5%, and it will probably be nearer zero," he says. The economic slowdown will not be confined to Germany, he says, forecasting euro-zone stock indices will be flat by mid-year.

The German tax reform will really take its toll in the short-term on corporate profits, says Ben Funnell, European equity market strategist at Morgan Stanley Dean Witter. "We had to halve our earnings per share growth forecasts from 8% to 4% for 1999," he says. Nevertheless, MSDW is still positive on Europe, and remains overweight in equities in a mixed-asset portfolio. Funnell sees 10-15% upside for the MSCI Europe index on a six- to 12-month view.

But stock markets in different European countries will tell different stories over the next six months, says Alex Ions, European equities strategist at Dresdner Kleinwort Benson. "Especially within euroland we see potentially divergent growth in earnings, essentially because of the single monetary policy ... you will end up with quite divergent levels of stimulus," he says.

In Spain and Italy, for example, the low level of euro-zone interest rates will be translated into higher earnings growth, he says. Growth and inflation will rise above what will be considered normal levels for euroland as a whole, he adds.

Normally this overheating would constitute an investment risk, but with the single currency there is no danger of a currency devaluation to bolster competitiveness. While some stock sectors, such as manufacturing, could suffer as inflation erodes competitiveness, others may become good investment opportunities. Typically shares in banks, property and construction would gain, says Ions.

Nick Stevenson, head of European equities at Paribas, says European pension funds have already changed their thinking and their asset allocation more radically than anyone thought. As an example, he cites a fund manager who has found that three quarters of his German mandates have now become European mandates. And of the 75% no longer specifically German, 40% are pan-European and 35% euro-zone. He notes that large amounts of investment money are now focused on Europe, rather than just the 11 in-countries.

The much-heralded switch from country-based to sector-based investment is already apparent. "The blue-chip outperformance we've seen is the most obvious indication of that," says Stevenson. The tightening sector correlation will continue as an inevitable consequence of the single currency, he says.

There have been, and will continue to be, differences in the performance of national bourses within Europe. But this is because national bourses differ in terms of their dominant sector. For instance, Norway's Oslo stock exchange index has lost about 35% since May. But this has more to do with the high percentage of oil stocks in the index than any market view of the economy, says Stevenson.

Country and sector are now of roughly similar importance as stock price performance factors, says Funnell. But over the next six months, the sector factor is actually likely to decline, he says, as re-benchmarking, particularly for insurance funds, creates great divergence between sector winners and losers.

Ions believes the euro will be positive for euro-zone stock markets in the first half of next year, because of a technical factor. "Institutions have been holding off reinvesting and investing new funds until the euro is established," he says. "One suspects they are under investing and could be holding cash." These cash holdings will inevitably be ploughed back into equities at some point.

The changeover to the euro is already having profound effects on the levels of turnover in European stocks, he says. At the end of 1998, stock turnover has decreased. "People were concerned that trades set up in December for one month's time might face difficulties ... because of the potential chaos," says Ions. There were worries that counterparty computer systems may not intitially be able to handle the change."