Recent economic and political developments have pushed Europe into the limelight, says Barclays Global Investors' chief economist Haydn Davies.
European profits defy the economic malaise
Germany's economic plight has been attracting fewer newspaper headlines lately. This is not due to any sign that it might be easing, but rather because the spotlight has fallen on Italy, which has slipped into its worst recession since 1992. Like Germany, Italian consumer spending has stagnated in recent years, although the 8.0 per cent unemployment rate is at least lower than Germany's 9.8 per cent.
However, whereas Germany has made up for the sluggishness of consumer spending with a moderate export recovery, Italy's trade performance has only exacerbated its problems. Before the introduction of the Euro, Italy was able to rely on a depreciating currency to offset the country's loss of competitiveness from runaway inflation. Italy no longer has that option and with inflation still higher than its euro zone peers, it has once again returned to running a trade deficit.
To compound Italy's problems, a large part of its industry still specialises in the production of basic consumer goods such as clothing and furniture. These products have been facing increasingly heavy competition from low cost producers in Eastern Europe and Asia. German firms, on the other hand, have benefited from strong orders for machinery and equipment, global demand for which has been upbeat.
German firms have also responded better to the threat from Eastern Europe, using the prospect of relocating factories to Poland and the Czech Republic to persuade workers to accept less generous wage rises and new working practices. Italian profits have rebounded 40 per cent from the nadir they reached in the summer of 2003, persuading investment analysts to upgrade their profit forecasts. However, the German and French markets have enjoyed stronger profit growth and they offer investors the best value. Moreover, there are tentative signs that activity will pick up in the second half of the year, although any recovery is likely to remain fairly lacklustre.
Nevertheless, the ability of European companies to deliver strong profit growth despite the weak economic climate means that equity markets look good value, particularly compared to government bonds, where 10-year yields have fallen to just 3.3 per cent. European equity markets have comfortably outperformed Japan, the US and the UK this year and that looks set to continue in spite of the economic malaise.
The French referendum on the new European Union constitution has also kept the region in the limelight. In practice, the biggest repercussions of France's "No" vote will be felt by those countries, such as Turkey, with aspirations to join monetary union. The economic impact in the euro zone should be negligible, with the European Central Bank (ECB) for example continuing to operate as before.
Nevertheless, the referendum result appears to have tarnished the euro a little. That said, the main drag on sentiment remains the sluggish economic climate and the expectation that the ECB will not raise interest rates until spring next year, at the earliest. For the moment, therefore, the euro will continue to slide
on the foreign exchanges.
UK retailers' gloom
Poor trading results from Marks & Spencer and high-street chemist Boots raise few eyebrows these days, with both companies having seen better times. However, other high-street chains such as music retailer HMV, electrical retailer Dixons and DIY chain Kingfisher, have begun to echo the warnings from Boots and Marks & Spencer, suggesting that the downturn is more widespread. Consumer spending has been cooling noticeably ever since the Bank of England began to raise interest rates last August, and the value of retailers' non-food sales is now lower than it was a year ago. The last time consumer spending was so weak was in 1991, when the UK last experienced a recession. That slump also had its roots in a slowdown in the housing market.
House prices have risen just under 2 per cent over the past 6 months, whereas a year ago they were rising 10 per cent every 6 months. Over the past few years, soaring housing prices led to a boom in mortgage equity withdrawal - mortgage borrowing not invested in housing - which boosted consumer spending. However, that boost is now fading in line with activity in the housing market.
However, the UK does not look to be on course for its first recession in 14 years. Activity in the housing market has improved - mortgage approvals bottomed last November - although business is much weaker than estate agents have grown accustomed to over the past few years. More importantly, the downturn in the housing market has not dented consumer confidence, which is still upbeat thanks to low unemployment. Unless unemployment climbs sharply, a full-blown consumer slump looks unlikely, but retailers will have to get used to leaner times for now.
The economic climate will also remain a drag on the UK equity market for the time being. Moreover, the UK stock market has looked a little expensive compared to markets elsewhere for some time. If the softer economic climate means that UK firms cannot produce the earnings growth to justify their premium rating, investors are likely to look elsewhere.
The slowdown on UK high streets has also caused a change of heart in the money markets, with the futures market now expecting a cut in UK interest rates before the end of the year. Moreover, in its latest Inflation Report, the Bank of England scaled down its forecast for the path of inflation over the next couple of years. The interest-rate outlook has knocked sentiment towards the pound. However, yields remain attractive by international standards and the currency's recent fall from favour is unlikely to last for long. The turn in interest-rate expectations is good news for the UK government bond market and yields have looked good value compared to other markets for some time. As a result, UK 10-year government bonds should continue to outperform markets elsewhere.
Better US news allays investors' concerns
Last month a range of indicators from retail sales to factory orders suggested that activity had cooled a little, sparking fears that the US recovery could be running out of steam. Economists began revising their growth forecasts downwards, bond yields reversed their previous climb and Wall Street lurched lower. The better news is that the same indicators that spooked investors have improved over the past month and statisticians have revised up their estimate of growth in the first quarter. These improvements have helped to allay investors' concerns.
Nevertheless, business confidence and retail sales volumes have been weakening for the past year, pointing to a continued slowdown in the pace of corporate earnings growth. While consumer spending has cooled, it has not softened as much as might have been expected given the weak jobs market and the impact of higher petrol prices. One reason has been the strength of the housing market with house price inflation at its highest since the early 1980s, boosting households' wealth. The labour market has also been gradually strengthening and employment is now growing at its quickest rate since the end of the technology bubble in early 2001. The improvement in sentiment towards the economic outlook has lifted Wall Street, although it remains lower than the level at which it started the year.
Although the improvement in sentiment about the economic outlook has pushed Wall Street higher, 10-year bond yields have continued to slide. Inflation remains subdued, with underlying inflation cooling slightly, which should persuade the Federal Reserve to continue tightening policy in gradual steps. However, with 10-year bond yields just above 4 per cent, government bond markets elsewhere look better value, as do US equities. US equities do not look such good value compared to markets elsewhere. This helps to explain why Wall Street has generally underperformed this year and should continue to do so, despite the US economic climate being so much stronger than it is in Japan or Europe.
The US dollar has fallen back into favour in recent months and its prospects look much better than they did only a few months ago. The trade deficit remains a drag on sentiment, but the US should find it easier to finance with money-market yields at their current level of 3 per cent, compared to a year ago when yields were just 1 per cent. The prospect of further rate hikes and the diminishing chance of an increase in euro zone or Japanese interest rates over the short term have boosted sentiment towards the US currency and its rally should have further to run.
Japanese exports continue to shrink
Ever since the collapse of its bubble at the beginning of the 1990s and the stagnation of domestic demand, Japan has become more reliant on foreign demand to kick-start growth. The bad news, therefore, is that a slump in export orders has left Japanese exports lower than a year ago. However, in the first quarter of 2005 the economy appears to have shrugged off the sluggishness of export sales, growing 1.3 per cent and more than making up for its contraction over the previous nine months.
Nevertheless, Japan experienced a similar jump in activity in the first quarter last year, which quickly evaporated. That rebound was also fuelled by a surprisingly robust recovery in consumer spending and strong stock building, which unwound over the following few months. The prospects do not look much more promising for the recent pick up in activity. The main reason for the increase in consumer spending has been the boost from buoyant end-of-year bonuses. These profit-related bonuses are paid every six months and can amount to several months' earnings. December's bonuses were lifted by the boost to profits from strong export sales earlier in the year. With export sales having since dried up, the outlook does not look nearly as favourable for this summer's bonus payments. Household spending, therefore, is also likely to wane and with export orders subdued the economic climate remains very fragile.
The weak economic climate has dragged Japanese equities lower so far this year and helped to push valuations to their cheapest levels in around 20 years. However, with the economic environment still so weak, the Japan stock market is still no bargain and is likely to continue underperforming. Even government bonds, offering a yield of just 1.3 per cent, look more attractive in the current climate. The sluggish pace of activity also poses an obstacle to the Japanese yen, since the Bank of Japan will not raise interest rates as long as the economy remains stuck in deflation. Moreover, with currencies elsewhere offering investors a higher yield, the yen looks to be in for a prolonged weak spell.