Buttonwood
An odd time to be risingJun 14th 2005
From The Economist Global Agenda
SourceEurope’s share prices are rising smartly even though Europe itself seems to be falling apartDOES it strike anyone else as odd that European shares are jumping ahead these days? The future of the euro, perhaps even of Europe, looks more than a bit uncertain. Each new economic statistic is soggier than the last. Yet France’s CAC 40 has risen by 1.7% since its citizens voted against the proposed European constitution, and it touched a three-year high en route. Frankfurt’s DAX has gone up by 3.5% and the pan-European FTSEurofirst 300 by 3.1%. America’s S&P 500, meanwhile, has risen by a mere 0.2% and the Dow Jones Industrial Average has slipped by 0.2%. Looking at total returns, which include dividends along with share-price movements, the pattern is the same. And so it has been since before the beginning of the year.
At first glance this looks like another conundrum. Economic growth in the euro area is likely to be just 1.4% this year, according to the European Central Bank, and most expect the forecast to be cut again before long. Of the zone’s biggest economies, Italy is in flat-out recession, while France and Germany are barely growing, with unemployment of around 10%. Britain, outside the euro area, has enjoyed good economic growth, but house prices are now trending down and consumer spending is slowing. Across the Atlantic, by contrast, the United States is growing at about 3.5% and unemployment is just over 5%. So, why are European shares doing so well?
The first answer is that they aren’t, exactly. As the chart below shows, translated into dollars, European shares have done roughly the same as American shares. The dollar has strengthened by over 12% this year against the euro, and is likely to strengthen further as the gap between American and European short-term rates increases.
This means that foreign investors in euro-area shares have seen some of their profits lost in translation. But the strong euro had been a millstone around the necks of Europe’s exporters: Italy, of all places, became a net importer of shoes last year. The weaker euro brings hope of export-led growth. Among the higher-flying European shares these days, points out James Barty, head of tactical asset allocation at Deutsche Bank in London, are those that are most sensitive to exchange-rate moves. These include Richemont, a luxury-goods maker, whose stock has risen by 13% over the past month, and capital-goods manufacturers such as SKF, which is up by 7.5%.
A recent shift in expectations about interest rates is another part of the answer. As recently as a couple of months ago, their likely direction seemed to be upwards in America and undecided in Europe. Investors now seem to reckon that the Fed will soon find lower growth a greater threat than higher inflation and stop hiking interest rates—though a rise looks virtually certain later this month. Ten-year Treasuries have recently flirted with yields below 4%. In Europe the ECB is being pressed to cut short rates, and most expect the Bank of England to lower rates.
When bond yields fall (ie, bond prices rise) and look likely to stay down, shares tend to look undervalued by comparison—and investors rush in. This is happening, to some degree, in both America and Europe. But there is a difference. Europe’s shares are relatively cheaper than American ones to start with, and its bonds are dearer. Yields on ten-year German Bunds, for example, are 93 basis points lower than the yield on ten-year Treasuries. Euro-area shares, meanwhile, are selling for 13 times forecast 2005 earnings, on figures from Deutsche Bank, while S&P 500 shares are trading at price-earnings (p/e) multiples of 16. So the comparison between dividend yields and bond yields favours shares even more in Europe than it does in America.
It is a bit misleading to compare share indices across boundaries, because their sectoral composition can be quite different. Europe, for example, is reckoned lighter in growth stocks than America, so some argue that it is logical for the index to reflect lower p/e multiples. Stripping out sectoral differences, however, Mislav Matejka, head of European equity strategy at J.P. Morgan Chase, finds that European shares (excluding health care) sell at a 15% discount to American shares.
Is that discount justified? Probably not. True, share prices are supposed to reflect expectations about future profits, and long-term trends favour America. Productivity is increasing faster there than in Europe and its working-age population is decreasing more slowly, so a growth gap of some magnitude is likely to continue. But Europe has the edge in two respects.
First, European firms are better placed to react to their common dilemma: competition from emerging countries with low wages and high investment rates, which is also pushing up commodity prices. With virtually full employment in America, companies cannot squeeze labour costs to compensate; in fact, unit labour costs are rising. In the euro area, where unemployment is high, companies can continue to lean on real wages. In addition, while companies on both sides of the Atlantic have healthy balance sheets after a couple of years of paying down debt, European firms deleveraged more, says Luca Silipo, an economist at IXIS CIB in Paris. European profits should therefore be more robust, despite lacklustre economies, and so should shares. Indeed, they have been since mid-2004, reckon the team at IXIS CIB.
The second point is that, for all its deservedly bad press, Europe’s monetary union has done some of what it was supposed to do: make companies streamline and become more competitive. Germany is the main example of a country where some tough restructuring has taken place. The current wave of mergers and acquisitions, which has boosted the share prices of European firms in recent days, is one sign that whatever the politicians think Europe has much to gain from consolidation. The €15.4 billion bid for German bank HVB by Italy’s UniCredit, agreed on Sunday, is Europe’s biggest cross-border banking takeover but it will not be the last one.
So should we all race out and buy Siemens shares? If you believe that the Fed is about to hang up its rate-hiking jersey, then yes, for a bit. But some of the cannier heads are not so sure. Rolf Elgeti of ABN AMRO warns that there is a “significant possibility” that the market is wrong, and that the Fed will keep raising rates on signs of continued inflationary pressure. If so, equities could see severe setbacks. And David Bowers of Merrill Lynch points out that if the euro is weak because markets sniff the end of restructuring in Europe, or equities look cheap because of lower interest rates that tell us deflation may be returning, these are hardly positive signs for an asset class that depends on growth.
At the end of the day, big companies are ever less anchored to the domestic economy in which they are domiciled anyway. Siemens sells more than half its products outside Germany; Nokia is a play not on Finland but on global demand for mobile phones. So Buttonwood’s answer is to look for long-term investment in anything that is yield-sensitive and selling at fair value (among utilities, oil and gas, telecoms, insurance), and for short-term investment among potential takeover candidates—and it doesn’t much matter whether you buy it in America or in Europe.
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