Portugal: High prices cause concern
The Portuguese economy is a prime candidate for EMU membership, with sound economic fundamentals resulting in a dramatic rise in the stock market already up 40% this year, following a rise of 36% in 1996.
Some analysts are now expressing concern, however, about overvaluation with the p/e ratio at 23. Jose Tomas, deputy director at BPI in Oporto, says: We have a large financial sector which should be weighing down the p/e ratio, therefore my perspective is that equities are becoming quite pricey at the moment. As a result, I am not bullish on the market, but I am willing to concede that there are strong liquidity flows. Given that we are in a very low interest rate environment maybe these levels are sustainable." However, he cautions against entering the market at this point predicting below par returns.
Pedro Batista, responsible for Portuguese research in SBC Warburg in London, is more bullish. "There are good fundamentals for companies backed by sector themes so it is the best of both worlds. Valuations have never been so high but they obviously reflect some kind of convergence with European multiples. The market still has more to go with increasing sector exposure such as electricity and other companies coming to the market."
In terms of market drivers, Tomas highlights low interest rates, liquidity flows and good earnings growth, adding that the market's inclusion in the MSCI, due on 2 December, and likely early membership of EMU are the two factors justifying a market re-rating.
Apart from the benign interest rate climate, Batista sees the entry to the MSCI coupled with the privatisation of Electricitade do Portugal (EdP) as one of the main drivers. "Given the amount of times it is oversubscribed, there is quite a strong flow of funds. Most of the people will not get what they want but they will look for other large cap stocks: that is why the large caps have been performing so well."
Both Tomas and Batista believe that any risks are external. Tomas says: "Basically every European market and the US is turning expensive. Should something happen in the US it will have ripple effects in Portugal and we would correct accordingly."
On an economic basis alone, he believes Portugal should gain entry to EMU, but the country could find itself included in a political deal with Spain, Italy and enter later. He predicts inflation at 2.5% by the end of the year, a public debt to GDP ratio of 62.5 and the spread with the Bund to change from 70 to perhaps 50. "If that isn't convergence, what is convergence?" he asks.
Francesco Garzarelli, associate economist in the economic research department at Goldman Sachs in London, agrees with this assessment, predicting a convergence to 50 basis points: "EMU is closely linked to investors' assessments of these markets. As there is a clearer picture of the EMU timetable and this risk premium is taken off this convergence will probably continue."
Batista sees strong earnings growth in a number of sectors. Infrastructure-related stocks should do well, due to large investments in the next three to four years. Banks will benefit from the good economic conditions and GDP growth and retailing will be boosted from increased consumer confidence. He also recommends growth stocks.
Garzarelli largely agrees with the benign picture painted by the analysts, pointing out that due to falling food prices, inflation in April fell from 2.5% to 1.8%.
"The prospects are still positive, supporting the bond market and keeping interest rates low. Limited data on the labour market, on contractual wages in particular shows a deceleration from the 4.5 average rate they recorded in 1996, to 3.8. This should temper inflation pressures."
Assessing the reasons for Portugal's success, in comparison with Italy and Spain, he says: "The economy grows at a faster pace because Portugal is basically a poorer economy. It is like having an emerging market in a very tightly linked economic area with big growth prospects with Germany as main export market." John Lappin"