Comment: Outlook for Europe: Ewen Cameron Watt, Head of Global Investment Strategy Research, Merrill Lynch Investment Management
Ewen Cameron Watt says evidence of a European decoupling from the US economy is mounting, and looks at the implications for European equities.
The sell-off in May and the first half in June reflected the emergence of inflation concerns, which raised the possibility of more aggressive monetary tightening, particularly in the US, with adverse implications for economic and profits growth. Markets had become more vulnerable to such a move given the run up in some of the more cyclical plays in equities in the preceding months, and the correction became more violent once these positions began to be unwound.
Excluding the period of the 'Baghdad bounce' in March 2003, one has to go back to the trough of the bear market in October 2002 to find a higher degree of volatility. This was exacerbated by the escalating conflict in the Middle East, which helped push oil prices to a new record high of over USD 76 per barrel in July. Volatility is generally lowest during the early stages of economic expansions, when growth is above-trend but there is still spare capacity. It tends to increase after capacity pressures begin to emerge and remains higher on average until well into a downturn. While we do not think that this cycle is coming to an end, we recognise the capacity pressures are starting to materialise and so we expect equity volatility to increase somewhat over the coming months.
However, as evidence mounts of slower economic growth elsewhere, the Eurozone continues to show resilience. Despite the rise in oil price and the ECB's monetary normalisation, European data has been strong. For the first time since 2001, the first quarter saw GDP growth in the region exceed that of the UK. Moreover, performance has been more broad-based than is often realised, with year-on-year growth in Germany, France and Italy around 1.5% and most momentum in the latter. France, meanwhile, has seen a pickup in consumer spending which may be driven by a World Cup effect but also points to declining savings ratios. The tentative signs of a slowdown in leading indicators (such as the IFO expectations index) have failed to sustain their downward move.
At the margin, evidence of a European decoupling from the US economy is mounting. However, we regard this as an early stage in the rebuilding of the European growth engine, and so think it likely that a response to the
US slowdown will emerge during the second half of 2006. Inflation data has been biased upwards by some easy comparisons, but the overall picture should remain benign with real household income growth still muted. We expect the European Central Bank (ECB) to continue its gradualist approach to interest rate hikes and view talk of acceleration as misguided.
Analysts remain confident on the European earnings outlook, with the region leading global upgrades over the last three months and forecasts now expecting double-digit earnings per share (EPS) growth this year and next. This still tracks behind the US, though we remain concerned given how extended earnings have become against trend and the historic exposure of European performance to the global cycle. Dividend payout ratios are at their lowest for 25 years, placing emphasis on buybacks and M&A as sources of shareholder return.
In the following months and from a global perspective, much will depend on evidence of inflation and how the Federal Reserve (Fed) manages the delicate balance of maintaining economic growth while keeping inflation in check. Until investors see more clarity in terms of both inflation and monetary policy, we believe equities are unlikely to experience a renewed upswing. This tug of war is likely to continue over the next couple of months, which should keep volatility levels relatively high. Using the VIX (the volatility on the US S&P 500 equity index) index as a measure of volatility levels in world equity markets, we would expect volatility to remain in a range between 14% and 18% over the next few years. This view is based on the assumption that economic growth stays around trend and that inflation measures (as proxies for economic volatility) do not spike.
Overall, our economic views and market observations support a continued pro-cyclical stance - we believe equities are undergoing a fairly typical correction within an ongoing cyclical bull market. The two conditions for a bear market are not in place: Valuations are not extended and we do not expect a profits recession. European valuations are undemanding, especially after the recent sell-off, and corporations generally have healthy balance sheets and have shown a willingness to accelerate share buybacks in the face of lower stock prices. While stocks may struggle somewhat into the fall, they should outperform on a 12-month basis.
Energy and materials remain our preferred sectors. Much may depend, however, on how far the ECB raises rates. If rates rise more than expected and the euro rallies, not to mention headwinds from elevated energy prices and increased geopolitical tensions, European equities may find it much harder to make progress.