Two developments in the US hold the key to how the Euro-zone equities market is likely to perform in 2004. One is the recovery of the US economy and the other is depreciation of the US dollar. The questions the European markets are asking are – will the fall in the dollar stunt earnings growth in continental Europe and will the US recovery be sustainable?
Norbert Beiner, head of European equities at Credit Suisse Asset Management, says: “Overall there are a lot of question marks at the moment – what will work and what won’t, when interest rate increases what will happen, how quickly they will happen, and what the dollar does.
“The market has had quite a nice run and we have already priced in quite a lot of the recovery. So going into next year the economic recovery in the US has to prove that it is sustainable. There is the question mark at the moment. They need to create jobs that are really sustainable, which will help to bring economic recovery to continental Europe.”
The depreciating dollar is the second big question mark. “The dollar is very critical even though it is only half of the story, since the trade-weighted euro did not suffer as much as the euro against just the dollar. Nevertheless it certainly did not help the relative competitiveness of European companies versus the US and did not help the earnings growth expectations for next year.”
Beiner suggest that a weakening dollar could mean a slight downward revision of forecasts of earnings growth in Europe next year. “IBES has a figure in the mid teens for earnings growth next year, but this figure was arrived at when the dollar was stronger. So I expect the earnings growth expectations to come down to somewhere between the low teens or high single digits.”
As the difference in stock valuations between cyclicals and growth stocks narrows, the focus will shift from companies that benefit from economic recovery to companies that are showing steady top-line growth, he suggests.
“We are currently still positioned for cyclical recovery, but I think that over the next year that might have to change. Assuming the recovery will succeed and we will have a economic recovery in continental Europe then I think during the first half of the year that will be priced in fully and the differences of valuations between the cyclical stocks and the restructuring stocks and stable growth stocks will be too small. We are going then into an area where I think you should be ready to pay more for stable growth in the foreseeable future.
“Last year was about restructuring, balance sheet repair and cyclicality, and buying into this was the right thing to do. But as we go into quieter, less turbulent times then we might have a look at the stability of the growth of the earnings. The stock market might be ready again to pay a little premium for steady growth companies, so these kind of stocks might deserve a better valuation.”
William Davies, head of European equities at Threadneedle also sees a change in the what will drive the market in 2004: “There is a subtle change in the breakdown of earnings growth, from mainly cost cutting to a bit more in the way of genuine revenue growth, and we believe that this will drive markets as we go through to 2004.
“Because most companies’ balance sheets are currently pretty lean, if you get some top line growth coming through, we believe that there could be some upside surprises in earnings for next year. So we will be looking for companies that have the scope to grow their sales as well as keep control of costs.”
Another development in the Euro-zone equities markets in 2004 could be a switch from a focus on beta stocks – companies that beat the benchmark – to companies with real growth prospects. Keith Wade, chief economist of Schroders, says: “The Euro-zone is a very high beta market, and if you are very bullish about equities you go into the Euro-zone. Some would call that lazy thinking but I don’t agree. Euro-zone equities have performed extremely well, and we’ve been overweight in Euro-zone equities, although we’ve brought it back slightly now.”
However, he suggests Euro-zone investors will look for something different if the dollar continues to weaken against the euro. “What concerns me as an economist is the weakening of the dollar this year. Until now investors have concentrated more on the beta of the market and rightly so. We’re still expecting earnings growth in the Euro-zone. But once you start to get disappointments in earnings, markets are going to want to see more growth. They will see growth in US but will they in Europe? So Euro-zone equities could be an area where we reduce our weighting in 2004.”
With the recovery is almost fully priced in to equity prices, the market is now looking for US-style growth. It seems unlikely to get it. Haydn Davies, chief economist of Barclays Global Investors, points out that that although business confidence is up in the Euro-zone, the labour market and consumer spending is likely to remain weak until well into 2004. The consensus amongst forecasters is that the Euro-zone economy will grow only 1.7% this year, he says – a little better than Japan but less than half the rate of the US
“The European recovery still looks pretty fragile and the improvement in the European economy is already reflected in equity prices. But European markets still offer some value and so should be able to make modest progress.”
Everything, as ever, depend on what happens in the US in 2004. If the recovery is sustainable and the depreciation of the dollar is managed, European equity markets could enjoy a prosperous New Year.

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