After a strong and sustained recovery in Euro-zone equities that started last year, asset managers are now asking how long has the recovery yet to run.
The answer will depend to some extent on valuations. Are Euro-zone stocks still fairly valued or has the recovery made them too expensive? Catherine Reilly, chief economist at Pohjola Asset Management in Helsinki, suggests the factors that have underpinned the upturn in the European equities market are still in place: “Valuations are still fairly reasonable, particularly taking into account the low rate of interest at the monument. If you look at dividend yields , the dividend yield on the Eurostoxx is just slightly below 3% and the 10 year interest rate is 3.8%. So certainly compared to bonds, shares still look very reasonably priced.”
Whether the recovery continues will also depend on whether companies deliver the earnings they forecast. Again, Reilly is optimistic. “The good news on the earnings front is that since last summer earnings have been pretty well in line with expectations. So whereas formerly we were having to revise our earning estimates downwards all the time , with constant disappointments, right now they seem to be pretty well in line with expectations.
“So although prices have risen, valuations haven’t risen that much. Earnings forecasts have remained more or less stable, and earnings should improve this year. That means that the justifiable valuation has also risen.”
Interest rates are likely to remain unchanged, she says. There is speculation that the European Central Bank (ECB) is likely to further lower the interest rate from its currently low level. However, Reilly is doubtful: “I would say that the ECB is very firmly on hold for the time being.”
So far the euro’s strength against the dollar does not appear to spoiled the party, she says: “Global growth has offset the effect to some extent.” The current exchange rate is not very far away from the rate of entry to the EMU. “And if you look at the trade-weighted exchange rate, we’re pretty close to the long term average.”
Adriaan de Mol van Otterloo, specialist European equity fund manager at Schroders in London, is also sanguine about the effects of a strong euro: “Exporters are benefiting from recovering demand overseas, which has so far more than offset the impact of the stronger euro. Our own forecasts factor in GDP growth of 2.0% in 2004, in line with long-term trend growth and slightly ahead of consensus.”
De Mol van Otterloo points out that the European corporate sector is healthier after a period of restructuring that has involved cutting costs and repairing balance sheets by paying down debt. “This has fed through to profits. Indeed, 2004 could well see the initial earnings expectations for the full year exceeded by the actual outcome for the first time in a number of years.
With inflation under control, interest rates in Europe should remain low, he says. Schroders forecasts rates to remain at the current level of 2% for the remainder of this year.
Yet there are a couple of clouds on the horizon, De Mol van Otterloo says. One is the continuing weakness of the US$ European companies in industries which depend on the US for a large proportion of their revenues will struggle if the euro continues to climb against the dollar, he says. Commodity-related sectors and technology, automobiles and capital goods will be particularly vulnerable.
De Mol van Otterloo says: “We think the market environment will increasingly become one suited to selective stockpicking. Those companies that are increasing profits through revenue growth rather than solely through cost-cutting measures will be best rewarded in the quarters ahead.” He adds: “Companies that experienced the worst earnings momentum outperformed significantly last year. This is at odds with the long-term trend in which companies experiencing better earnings momentum outperform. This period of underperformance by best earnings momentum now appears to be stabilising.”
De Mol van Otterloo suggests that investors who choose only those stocks which look most attractive from a valuation perspective can expect another good year in Euro-zone equities.