As anticipated at the end of the second quarter of the year, the recovery of the global real economy is beginning to have an effect on Euroland equities.
Some sectors, such as energy and construction, continue to overperform, and managers are still content to be overweight in cyclical stocks. Most analysts, however, question how long this can last.
Roger Hirst, joint head of euro equities with Dresdner Kleinwort Benson in Frankfurt, sees this as the key question. “This has been a year which has seen a fantastic rally in cyclicals, can it continue? The answer to that is probably to be found in the global economy figures. Stocks have clearly been affected by both commodity prices and the low exchange rate of the euro.”
The latter has seen growth accelerate across the region with exports up 17%. But with commodity prices increasing as the global economy accelerates, Hirst thinks that sectors such as oil, metals and mining may already have gone too far. “Nevertheless, there is still plenty of potential for engineering and chemicals to perform well as the economy accelerates.”
There is no question but that the second half of 1999 was always going to be more nervous than the previous six months, as pre-millennium tension begins to grip investment managers and the markets. This may explain another major concern of analysts, the lack of liquidity.
Mark Tinkler, head of European equity strategy at Warburg Dillon Read in London, believes something is happening on a global scale to precipitate the liquidity problem. “In basic terms the real economy is recovering as people realise that the fear of a worldwide economic collapse was overplayed last winter and earlier this year. Recently we have seen spreads move wider as demand for cash from the real economy has increased. At the same time large corporations in the US are raising cash through bond issues, and sitting on it, and investors generally are less prepared to take risks as the millennium approaches.”
Tinkler believes the next two months will be crucial. “We are seeing continued restructuring of the markets. Large conglomerates being broken up, and continual bond issues building war chests. With all this going on at the same time, equities are bound to suffer. Nevertheless, investors are always looking for genuine returns, and so some “catalyst companies”, with management teams generating their own profits rather than waiting for the economic climate to help them grow, will almost certainly attract interest.”
Hirst meanwhile is looking for faster growth across the region over the next two years, but worries about inflation targets.
He says, “We need inflation in the Euro-zone to remain under 2%, but oil prices are likely to push it above that early next year. If it does not drop back below that figure by the end of the first quarter the Central Bank will have to act to slow the economy.”
So far as stock picking is concerned, he expects the rest of the year to be represented by “quality but dull” investment. “Telecoms, pharmaceuticals and media will improve a little, as will industrial cyclicals, but insurance could be a sensitive area,” he concludes.
The continued buying of cyclicals, which are sensitive to growth, is echoed by James Barty, equity strategist at Deutsche in London. “We expect to see more of the same to the end of the year, with further interest rate hikes hurting sectors such as pharmaceuticals and telecoms, the latter having been the worst performing sector of late.”
He also expects inflation to increase worldwide as world economies continue to recover and synchronise, pushing up the price index in Euroland. The result will probably see equity markets fall and struggle to recover before the year end.
“We have a flat prediction over the year, and there is no reason to believe we will be very far out with that,” says Barty.
It may be that Hirst’s theory of “quality but dull” will be the benchmark to the year end, as the equity markets fall back to levels they enjoyed earlier this year.