European equity markets rallied sharply at the end of last year though this has been accompanied by a mild deterioration in valuations. Investors may well look to adopt a more cautious positioning given the very strong performance of equity markets over the past three years, the expected interest rate increases and the likely increase in global bond yields.
There is still quite a lot of uncertainty in the market and most of it is coming from the US where economic data continues to produce mixed messages. A recent bond sell off, for example,was prompted by, on one hand, recent evidence showing signs that the environment is becoming more stable and, on the other, the Federal Reserve’s continuing concern over the inflation risks. No one can tell with certainty when the current downturn is likely to end.
Economic performance across the eurozone has exceeded expectations. The pick up in domestic demand has been helped by improved business confidence driven by strong corporate profitability, and consumer confidence driven by strong job creation. However, GDP growth is still set to slow in both Europe and the US, pushing top line company growth down more than is currently discounted by the markets and inevitably impacting the bottom line profits growth. A number of positive developments in some of the eurozone countries should be helpful to firms, though, in this particular case, lower corporate tax rates will be partially offset by loss of allowances.
The main positive factor for the European stockmarkets remains ongoing consolidation, underpinned by significant private equity firepower. The scale of growth means they are able to consider much larger targets than before. Private equity firms are able to aggressively use cheap debt to make their return calculations stack up.
Even during the Christmas season, M&A activity remained high, with Norway’s Statoil acquiring Norsk Hydro’s energy assets and gathering rumours about a possible break up of the French utilities company Suez. Markets are also benefiting from the ongoing growth in share buybacks, higher payout ratios and higher dividends.
A more cautious outlook for European equities this year does not mean that the market won’t bring exciting investment opportunities. Areas that look attractive include banks operating in Greece and Central and Eastern Europe, as well as those companies and sectors benefiting from the further recovery in consumer spending.
Adrian Fowler is fund manager of the F&C MPF European Fund.
