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 There is still a chance of a nasty hangover as the fiscal stimulus gets withdrawn, but a more important trend is the notable pick up in trade.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.
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
The general term for the rate of income from an investment expressed as an annual percentage and based on its current market value. For example, if a corporate bond or gilt originally sold at £100 par value with a coupon of 10% is bought for £100 then the coupon and the yield are the same at 10%, or £10. But if an investor buys the bond for £125, its coupon is still 10% (or £10) and the investor receives £10 but as the investor bought the bond for £125 (not £100) the yield on the investment is 8%.
An increase in the general level of prices that persists over a period of time. The inflation rate is a measure of the average change over a period, usually 12 months. If inflation is up 4%, this means the price of products and services is 4% higher than a year earlier, requiring we spend and extra 4% to buy the same things we bought 12 months ago and that any savings and investments must generate 4% (after any taxes) to keep pace with inflation. Since 2003, the Bank of England has used the consumer prices index (CPI) as its official measure of inflation (see also retail prices index).
An interchangeable term for shares (UK) or stocks (US). Holders of equity shares in a company are entitled to the earnings and assets of a company after all the prior charges and demands on the company’s capital (chiefly its debts and liabilities) have been settled. To have equity in any asset is to own a piece of it, so holders of shares in a company effectively own a piece proportionate to the number of shares they hold. (See also Shares).
Generic, loosely-defined term for markets in a newly industrialised or Third World country that is in the process of moving from a closed economy to an open market economy while building accountability within the system. The World Bank recognises 28 countries as emerging markets, including Argentina, Brazil, China, Czech Republic, Egypt, India, Israel, Morocco, Russia and Venezuela. Because these countries carry additional political, economic and currency risks, investors in emerging markets should accept volatile returns. There is potential to make large profit at the risk of large losses.
If you own shares in a company, you’re entitled to a slice of the profits and these are paid as dividends on top of any capital growth in the shares’ value. The amount of the dividend is down to the board of directors (who can decide not to pay a dividend and reinvest any profits in the company) and they will be paid twice yearly (announced at the AGM and six months later as an interim). Dividends are always declared as a sum of money rather than a percentage of the share’s price. Although dividends automatically receive a 10% tax credit from HM Revenue & Customs (HMRC), which takes the company having already paid corporation tax on its profits into account. Dividends are classed as income and, as such, are liable for personal taxation and so shareholders have to declare them to HMRC.
The total money value of all the finished goods and services produced in an economy in one year. It includes all consumer and government consumption, government spending and borrowing, investments and exports (minus imports) and is taken as a guide to a nation’s economic health and financial well being. However, some economists feel GDP is inaccurate because it fails to measure the changes in a nation's standard of living, unpaid labour, savings and inflationary price changes (such as housing booms and stockmarket increases).