In economic terms, the only solace for equity investors is the likelihood that, with inflation likely to stay close to target, the European Central Bank will not need to raise interest rates aggressively. In response to this downbeat economic scenario, we have also halved our earnings estimates for 2005 to 5 per cent, a level markedly below consensus. Earnings downgrades should come as a result of disappointments at the top line as well as in margins.
Despite this, we remain reasonably optimistic as to the outlook for European equities. Although the growth environment has weakened, the market still offers good value, with a price/earnings ratio of around 14x for 2005. Furthermore, with bond yields below 3.8 per cent in the eurozone, the bond to earnings yield ratio still leaves equities looking attractive. At the same time, the equity risk premium remains at historically high levels.
On the plus side for the corporate sector, balance sheets are strong and companies can be expected to increase dividends. In fact, many European stocks now have dividend yields higher than their corporate bond yields. Further, labour markets appear more flexible than before. While this may not be good for economic growth in the short term as it keeps unemployment rates high, it is positive for corporate margins and relative competitiveness.
Our caution on possible earnings disappointments has been reflected in our reduction of autos. We have also selectively trimmed our exposure to telecoms after some strong performance, as margins are likely to come under pressure from fiercer competition and the possibility of increased regulation.
We will continue focusing on growth stocks, particularly where there is sustainable, above-average growth in revenues. As economic growth slows investors will again start to pay a premium for sustainable growth – an increasingly rare commodity.
Alex Lyle, head of managed funds, Threadneedle Investments
