European equities still trade at a 15 per cent discount to the US, even after the strong outperformance last year. The longer term average is a 10 per cent discount.
However, a word of caution: the potential for negative surprises has increased. For example, the rate of profits growth is expected to slow with more individual corporate earnings disappointments than in 2005. High commodity prices could yet cause a spike in inflation and bond market stress if interest rates also rise more than expected. The potential for a big slowdown in US consumer spending could easily knock equities off course, as could a new terrorist outrage or bird flu.
The twin forces of technological change and globalisation continue to serve up new opportunities and challenges. A second wave of internet-related innovation is already building, as is awareness that developing economies are potentially vast markets for consumer goods.
In December, for the first time in five years, the European Central Bank (ECB) raised interest rates by 25 basis points. The rate hike will have little impact on growth in 2006, which could be the Eurozone’s best in six years. New orders are rising sharply and business sentiment surveys are positive. Although the recovery has been primarily export-led, investment growth is beginning to offer support.
Although sentiment has improved, data continues to highlight a low propensity to consume. In the absence of a strong and sustained improvement in employment growth, the rate of increase in private consumption will remain lacklustre. However, this sloth-like consumer demand will not deter the ECB from raising rates further if needed. The market currently expects a further 50 basis point rise in rates in 2006. Meanwhile, the Bank of England could cut rates twice in 2006.
After five years of near stagflation, the German economy is in a strong position to experience the long-awaited cyclical upturn. Corporate profits are strong and wage pressures are modest; the export boom continues, and there are signs that investment is picking up. The downside lies in the oil price and the exchange rate.
Earnings momentum was a successful driver of sector performance through 2005 and suggestions point to it perhaps becoming a more important driver of returns in 2006.
Diane Jones, senior portfolio manager, European equities, Northern Trust Global Investments.
Jones: German economy in strong position
