Fund managers are positive about the outlook for European equities for 2007. Strong M&A activity and ongoing industry consolidation in countries such as Germany, France and Spain are set to continue. However, returns in the asset class are likely to be more modest than those registered last year.
“European corporations are undergoing changes based around outsourcing and offshoring,” says Michael Hughes, client portfolio manager, European equities at JPMorgan Asset Management. “They are transporting their businesses overseas in order to make themselves more competitive and to access higher growth markets,” he adds.
The casualty of such a trend has been high unemployment in some European countries but moving production elsewhere has had a positive impact on profitability and returns on capital which have been catching up with those in the US. “That has always been one of the main justifications given by people as to why European equities should be cheaper than US equities and now that justification is no longer there. And yet European equities are still a bit cheaper than US equities,” Mr Hughes adds.
Even though returns in the asset class have risen dramatically since the low point in the market in March 2003, price earnings (P/E) ratios have barely moved since. “We have figures that show European markets ex UK are up 125 per cent since March 03 but P/E ratios are only up 17 per cent, and that is why we remain very optimistic about the outlook for the future.”
Looking across the whole region, the eurozone economies look stronger compared to the growth prospects for the UK. There, the recent unexpected rise in interest rates by the Bank of England and the increased income and local tax burden make many believe the UK economy is set to slow down relative to the rest of the continent.
“Having been an economic outperformer for the last decade, we actually think there is more economic momentum in [Continental] Europe than there is in the UK, but in general we are still quite positive about the UK market,” says Neil Dwane, European CIO at RCM, the specialist equities arm of Allianz Global Investors. One of the reasons behind this reasoning is that the UK still represents one of the most free markets for M&A activity to take place. “Where we have big problems in the UK, and this in an issue for Europe in general, is that we don’t like some of the largest companies, like the UK banks and the two oil companies. We think these companies are dull and that we can do better elsewhere.”
A good backdrop
“Generally the eurozone economies are doing well and even Germany is doing its thing. We think this is a very good backdrop for the underlying economic activity and with interest rates remaining low this provides the fuel for this economic activity to continue,” Mr Dwane explains.
He adds, however, that the euro remains “the only shark in the water”, explaining that a weaker dollar could have a negative impact on returns. “At the current 1.30 [$/€ exchange rate] companies seem to be able to deal with that competitive exchange rate but where we see the big risk for European equities and profitability is if we see the dollar weaken to 1.40 or worse. But we don’t see that happening in the short term.”
Mr Dwane says the free cash flow yield on European equities is currently higher than that of the bond markets. “This suggests to us that bond and credit markets are overvalued and the equity market is undervalued. We therefore feel that a lot of institutional investors can see no value in the bond markets at all and are, almost by default, coming to the European equities and to some extent the European property markets.”
At Putnam, CIO of international core equities Simon Davis says European corporations remain an attractive target for private equity firms. “Clearly there is a huge amount of money that’s been accumulated by private equity funds. This is going to continue to drive equity market performance over the next few months.”
He explains that historically private equity firms have felt more attracted to Anglo-Saxon markets which tend to have a more accepting approach to M&A activity. “Those markets have been so targeted by private equity firms that opportunities have become more and more scattered and therefore they have started looking at other markets. Over the last decade they’ve been looking more and more at Continental Europe and we expect that to continue,” Mr Davis explains.
Beyond Western Europe, the Central and Eastern European economies present very attractive opportunities for investors who have been increasing allocations to the region
especially since the EU enlargement towards the East.
“I think people generally are missing out the opportunity that Eastern Europe represents. Just on our doorstep we have a few million people joining the EU, all of whom have the same type of aspirations as Western Europeans,” Mr Dwane says adding that unlike investments in Asia where companies have to establish joint-ventures with local partners, in Eastern Europe “you are able to own 100 per cent of the profits stream”.
“We are very positive on Eastern Europe and we believe the accession countries continue to offer tremendous opportunity for European companies to invest in. Also with the high oil prices, the halo effect of Russia sitting just behind the region is another very strong positive for consumption and growth.”
