Europe's recovery puts it in the spotlight

In the investment world, at least, it sometimes pays to be boring. Stuffy old Europe has been recovering steadily over the past year, led largely by France and Germany. Encouraging economic data and corporate results are paving the way for a return to positive earnings growth in 2010.

Many European companies have proved adept at transforming their operations to deal with difficult economic conditions, and the recovery is expected to broaden out beyond the cyclical companies that are currently leading the way.

Most analysts say equity valuations across Europe are not stretched, with price/earnings (p/e) ratios from 11 to 12 times expected 2010 earnings, which looks to be good value relative to other regions.

The bull run since March has lifted continental markets by 50%, but equity dividend yields are still attractive compared with government bonds.

However, obstacles to recovery still exist, such as increases in income and property tax, and rising unemployment, which continues to hurt the consumer. There is also uncertainty about what will happen when government-sponsored liquidity and incentive schemes start to wind down.

However, most fund managers believe valuations are too cheap. "Markets responded swiftly to government stimulus," says Dean Tenerelli, portfolio manager at T. Rowe Price International.

"Companies in Europe have been quick to run down their inventories and clear their working capital channels. With [high-yield corporate] bonds yielding more than 10%, the market's forward p/e ratio of 11% is not at all demanding. But equities could experience a correction in the near term."

"Compared with the US and the UK, Europe has plodded along relatively well through the economic crisis," agrees Gary Clarke, head of European equities at Schroder Investment Management. "France and Germany emerged from recession in the second quarter, partly as a result of the fiscal stimulus, which included government incentive schemes such as the 'cash for clunkers' promotion."

He adds: "Corporate earnings have been better than expected, although they are the result of cost-cutting rather than revenue growth. There is still a chance of a nasty hangover as the fiscal stimulus gets withdrawn, but a more important trend is the notable pick up in trade.

"Indeed, exports have driven the lion's share of growth for Germany and France. Developed Europe now only makes up 60% of total revenues for European corporates - 10 years ago this figure was around 70%."

What has changed is Europe's increasing trade with emerging markets, which now account for nearly 24% of the region's revenues and are much more important than the US.
So far, cyclicals have led the way, but some defensive sectors are attractive. Tenerelli particularly likes medium-sized companies in the technology and healthcare (ex-pharmaceutical) sectors, particularly those making high-tech machines such as Swedish radiation machine maker Elekta.

He also predicts a bounce back for financials - such as Credit Suisse, GAM and Julius Baer - and oversold stocks in the media sector.

One characteristic of Europe is the economic chasm between core European countries, such as France and Germany, and peripheral ones, such as Greece and Italy. This will result in a wide range of outcomes in 2010, according to Raj Shant, Newton Investment Management's director of European equities.

Japanese rally

In Japan, the stockmarket has benefited from the broad equity market rally this year and a recovery in industrial production, although, as a whole, it has underperformed, weighed down by recovery doubts, financial regulation, political concerns and a strong yen.

"While we acknowledge that the troubles surrounding the financial sector are not yet over, in our view a worst-case scenario has already been priced in after the sharp recent falls," says Shogo Maeda, head of Japanese equities at Schroders.

"Indeed, we believe good opportunities are opening up in this area of the market. Bank valuations, in particular, look cheap relative to other sectors and to history."

Doubters say the adjustment in inventories and government stimulus efforts are exhausted as forces for growth, and are sceptical that the Democratic Party of Japan government will be able to deliver on its promise of growth from domestic demand rather than exports.

"Japan is most influenced by trade with emerging markets, but the consumer in Japan has been under the kosh because of unemployment and the outlook is precarious," says Mike Turner, head of global strategy and asset allocation at Aberdeen Asset Management.

"Recent statistics indicate that unemployment is stabilising, but consumption is still weak. Capital expenditure is not a mainstay of growth and the consumer remains the Achilles heel."

US recovery fragile

The US is staging a recovery of sorts, but many agree with Federal Reserve chairman Ben Bernanke who said in December that it is too early to gauge whether it can be sustained.

Unemployment is likely to stay high, inflation will probably remain subdued and interest rates are expected to remain low, Bernanke said. Consumer indebtedness is high and deleveraging will take a few more years.

But while some analysts have been pumping up earnings estimates, Paul Mangus, director of equity strategies at Wells Fargo Wealth Management, says their expectations are often too high.

"Analysts' forecasts are too aggressive, with many anticipating a strong second half to the year and returns implying that the S&P 500 index will rise by 24%. Our forecasts are more moderate. We anticipate a 20% rise, not a hope and a dream of something better."

Inventory restocking is an area where many analysts predict a big boost to earnings, but he believes companies are taking a cautious approach in the absence of top-line growth. Instead, Mangus sees significant headwinds.

The consumer accounts for 60% of US GDP, he says, but customers are bargain-hunting and the residential property market is only stabilising because of artificial support. On the other hand investors are already concerned about how the Federal Reserve may unwind its stimulus efforts once the good economic data coming out in dribs and drabs appears sustainable.

Materials companies and technology firms are attractive, says Mangus, because capital expenditure has risen and spending on technology is high as companies look for productivity gains.

There are also opportunities in large companies that are benefitting from recovery in emerging markets, says Turner, but he nonetheless plumps for Europe over the US and Japan as a recovery play, owing to the strength of the euro.

This article was originally published in Money Observer - Moneywise's sister publication - in January 2010

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