Moreover, we are less concerned about slowing growth with countries such as China and India continuing to support demand. This is reflected in German business confidence, which was at a five-year high in October. In this environment our outlook for GDP growth remains at around 1.5 per cent for both 2005 and 2006.
With less pressure from rising inflation, central bankers can be expected to raise rates more slowly, if at all, and there is consequently less risk of higher corporate bond yields. European dividend yields of 3.1 per cent are marginally below those of euro bond yields of 3.4 per cent, but we believe that dividends are likely to rise with continued growth in profits and strong balance sheets. With European earnings yields over 7 per cent and a 2006 P/E of around 14x, equities are still cheap relative to bonds. At the same time, equity risk premium remains at historically high levels.
Corporations have started taking advantage of their healthier balance sheets as well as a relatively benign interest rate environment to grow their businesses through M&A activity. This is undoubtedly good for acquisition targets, however, there has been enough evidence that the acquiring company share prices can benefit as well, as we have seen with Pernod Ricard’s announcement of bidding for Allied Domecq.
Finally, companies across Europe, but especially in Germany are engaging in ‘self help’ – meaning restructuring. There was much discussion in September that the inconclusive result to the German general election would result in reforms that are vital to the recovery of corporate Germany being postponed, watered down or even shelved. We are less concerned as the companies themselves seem to have grasped the nettle irrespective of the political agenda. Indeed on the day of the election results Siemens announced job cuts, and this was soon followed by further restructuring announcements from blue chip companies such as Daimler Chrysler and Deutsche Telekom
Given our expectation of continued earnings growth in European markets in 2006 well supported by M&A activity, we continue to have a positive outlook on European equity markets. To this end, we remain invested in sustainable growth companies such as those in healthcare as well as energy and certain energy services stocks.
William Davies, head of European equities at Threadneedle Investments.
