Germany’s coalition has raised taxes but deferred reforms. Spain seems content with a massive housing bubble and a 9 per cent current account deficit. Italy is applying serious fiscal brakes. France is set to choose between one presidential candidate who thinks protectionism is a good thing and the other who would renationalise the electricity industry and abandon the source of 80 per cent of her country’s power.
The economic following winds have been strong with European gross domestic product (GDP) growth up from 1.2 per cent in 2005 to close to 2.8 per cent in 2006 and all of Germany, France, Italy, Spain, Sweden, Portugal, Switzerland and Norway seeing year-on-year acceleration. In 2007, the effects of tighter fiscal policies in Italy and German will kick in, rates could climb 50 points, while the US slowdown may hit export sectors.
Against this backdrop, what has happened to equities? For starters they have gone up a lot: returns of 21 per cent for Europe last year with real estate posting 57 per cent and metals almost doubling. Some of the catalysts are clear. Last year saw record levels of mergers and acquisitions (M&A) at $3200bn globally and $1200bn in Europe.
As the “gear it up and flog it off” cycle moved up, the private equity sector found itself with a record low ratio of investments to funds raised, with the result that the sector’s average deal size ballooned and quoted sector M&A reached a record 35 per cent of all spending during the year.
How have the businesses themselves performed? “Unbelievably” is the answer. If you look at European earnings per share back to 1970 you see that current levels are a full 35 per cent above the trend line. Using Deutsche Bank aggregates for European quoted companies ex-financials, net profit margins are running at 7.6 per cent, up 1.1 percentage points on 2006. On those numbers valuation looks reasonable; Europe trades at 13.4x 2007 earnings or 14.2x ex financials and yields 3 per cent.
One can indeed always find reasons to be less than cheerful – GDP growth expected to slow, record levels of M&A, rising interest rates and peak corporate profitability, but they miss the point entirely. Many of the issues raised above applied just as well at the start of last year as they do now. What they prove is that forecasting economies and markets is a mug’s game.
Ben Williams is manager of the Investec Pan-European Fund.
