Analysts at most brokerage firms predict that European exchanges have the best prospects of all Western markets in 2004. If that’s true, the large gap in performance between European and American markets last year will be reduced. Nevertheless, the largest menace to this scenario can be found in Europe itself. Threatening the favorable horizon for stocks are the risk that economic growth will be too mild, the excessive strength of the euro, and the consequences of the rupture of the Stability Pact.
The consensus among analysts at stock exchange firms is that the European economy will grow by between 1.5% and 2% in 2004, which is less than the numbers projected for the American economy. But if you ask analysts and strategists at the same firms, they won’t exactly choose Wall Street.
This apparent paradox comes from the contrasting behavior of American shares during the year recently ended, compared with European shares. While both the Dow Jones Average and S&P 500 shot up by more than 25%, and the NASDAQ Composite of technology firms rose by 50%, the pan-European DJ Euro Stoxx 50 barely gained 10.5% in value.
These advances have left a wide gap in valuation if you consider the P/E ratio, a statistic that measures how prices in a stock exchange compare with the earnings of companies. American markets now have a P/E ratio of about 20, taking as the base the earnings expected for 2004. Meanwhile, European markets are closer to 18.
For Joanna Luxton, director of investment strategy and fund manager at American Express, the context suggests that “the improvement in company earnings has been reflected in the price of many American shares,” so that “we prefer Europe as an investment zone.”
Agreeing with Luxton is Gary Dugan, director of European stock market strategy and fund director at J.P. Morgan Fleming. He believes that the markets of the continent “are undervalued.” Similar opinions are held by numerous strategists and investors at both European and American firms who believe that American companies have little more room to run up, despite the positive outlook for corporate profits.
If the most favorable omens come true, “ Europe would act like a trailer, towed behind the recovery of the United States ,” according to a recent report by analysts at Citigroup, the largest financial group in the world. Already, the macroeconomic figures are starting to look that way. During the third quarter of 2003, the United States surprised markets with an economic growth rate of 8.2%. The principal economies of the euro zone – the French and the German, which comprise more than 60% of the euro zone (GDP) – barely managed to get out of the quicksand of recession in which they had been trapped during previous quarters.
Those analysts who argue in favor of European shares use the earnings-per-share outlook as one of their main arguments. The expected growth rate for Europe during 2004 will be 15% for companies in the Euro Stoxx 600, while in the United States it will be 12%, according to JCF Quant, a French financial data consulting firm. The projections for Europe in 2005 also call for greater growth [than in the U.S. ], although at a more modest rate.
The Danger of Recovery Is at Home
Nevertheless, the favorable prospects for Europe ’s stock markets are endangered by a variety of conditions that, for the most part cases, have their origin in the continent itself. Federico Steinberg, professor in the department of economic analysis at the Autonomous University of Madrid, has a positive view of the exchanges but he stresses some risks. “Although the main economies of the euro zone are coming out of recession, it’s expected that the European Union will grow by about 1.5% in 2004. The appreciation of the euro with respect to the dollar, which already means about 50% from the time that the euro touched bottom almost two years ago, makes our exports more expensive. Meanwhile, inflation, which is reluctant to drop below 2%, does not permit the European Central Bank to reduce the price of money even more. Also, the collapse of the Stability Pact can generate inflationary pressures that do not favor the improvement of business expectations.”
Of these risks, the one that frightens analysts the most is the excessive strength of the European currency with respect to the dollar. The relationship between the two currencies is currently at about $1.28 per euro, which means that it is registering new historic highs, something that has kept happening since November, when the European currency moved above the level of $1.2.
A euro that is too strong has a negative impact on European companies. On the one hand, it means shrinking results for exporting companies when they transfer the revenues that they have obtained from the original currency into euros. On the other hand, it reduces their competitiveness since the products that the competition in other countries is offering have now become cheaper. Goldman Sachs, the American investment bank, estimates that each 10% rise in the euro with respect to the dollar takes away 4% growth in the profits of European companies. Patrick Lenain, an economist at the OECD, calculates that the 10% strengthening of the euro with respect to the dollar, over 12 months, means a 1% cut in the growth of the German GDP. German exports collapsed in October, but in November they revived, showing a growth of 4.1%, according to the latest published data.
In 2003, the euro rose by more than 20% with respect to the dollar, and predictions for the new fiscal year call for a gradual weakening of the American currency until at least the first half of the year. Currently, the gigantic current-account deficit – starting with the balance of payments that measures the gap between imports and exports of a country – is breaking $600 billion, or practically 5% of the American GDP. This deficit will continue to grow so long as the American economy grows at a rate that is higher than other Western countries because the United States will continue to need deposits from abroad to keep financing its deficit. This would provoke more downward pressure on the dollar, and make American assets cheaper, in order to attract cash to its economy.
The European Central Bank has not demonstrated excessive concern about the strength of the currency. Its president, Jean-Jacques Trichet, has defended a “strong and stable” euro. But it would be worrisome if the [dollar] depreciation were abrupt. As Federico Steinberg explains, “The United States needs to take in sizable amounts of cash each day to finance its deficit, and for this to happen it is indispensable that investors have faith that dollar-denominated assets have more value tomorrow than today. If this confidence is lost and there is a precipitous flight of capital, the financial system of the United States could be weakened,” and that would derail the economic recovery.
Nevertheless, although it involves a risk, this scenario isn’t what analysts and economists consider most likely. The most optimistic analysts recall that a strong euro also means imports that are cheaper for European companies. There are even some who, like Byron Wien, the strategist of American variable income at Morgan Stanley investment bank, act on the theory that the dollar will strengthen with respect to the euro, due to the uncertainties about economic policy in Europe .
The question now is to know what the ECB will do in the event that there is a sudden danger to recovery. On January 8, 2004 , the European monetary authority left interest rates at 2%, but more and more voices are critical of the ECB’s passivity. Among them is Joseph Stiglitz, a Nobel laureate in economics. In an interview with Financial Times Deutschland, Stiglitz expressed the need to cut interest rates in the euro zone by at least a half a percent, so that an overvalued euro doesn’t abort Europe ’s incipient economic recovery.
Oddly, there is also another hypothesis that, in the mid-term, can lead to pressure for the monetary authority to take the opposite decision – raise rates because of the tensions stemming from the rupture of the Stability Pact that was provoked by France and Germany. The heavyweights of the euro zone are not ready to comply with the requirement that they put the public-sector deficit at below 3%. As Steinberg notes, “The rupture of the Pact will mean more public spending, which could accelerate inflation. As a result, the ECB could become nervous and raise rates.” However, he does not think that this will happen. Joachim Fels, a European economist at Morgan Stanley, believes that the rupture of the Pact puts in doubt “the credibility of the European Union” and substantially raises the risks of a hike in rates on the part of the ECB. The investment bank hopes to start putting together a second version of the Stability Pact during the coming months.
At the moment, euro zone inflation, whose control is the main goal of the ECB right now, appears to be under control and economists expect that in 2004, “it will wind up within or below the goal of 2% that the monetary authority is driving for,” according to the analysis of a Citigroup service. José Luis Alzola, an economist at the largest financial group in the world, believes that “interest rates in the euro zone will be maintained at lower levels than the markets might assume, due to the weak economy and high inflation.”
According to a study that Bloomberg, the news agency, did with 54 firms, analysts and strategists, predictions call for the euro to reach a yearly high of $1.35 towards summer before correcting itself up to $1.25 towards the end of the year, if the ECB lowers interest rates and the Federal Reserve raises them.
Recommendations of the Experts
If Europe does not succumb to various uncertainties, the experts predict that European share prices in 2004 will enjoy an upward revaluation at a growth rate that returns to above double digits. According to a survey that Standard & Poor’s did among large fund managers, the expected return among managers of variable European income is 15.14%, compared with the average increase of 12.29% that is expected in the United States.
When it comes to sectors, each brokerage firm has its own predictions. However, most favor those companies that are more closely related to the revival of economic activity, as well as those firms that are not highly dependent on exports. That is to say, they favor companies that are most exposed to domestic consumption. Luxton of American Express has positioned her portfolio toward cyclical values, including “giving priority to those companies that are the biggest beneficiaries of business investment, as well as to the travel sector, to the detriment of manufacturers of discretional consumer products.”
The Morgan Stanley investment bank recommends that its clients give special attention to those industries that could take advantage of a hypothetical jolt that comes from merger and acquisition transactions, among which it also notes cyclical industries; telecommunications firms, and food companies. “All these groups are generating important quantities of cash – which are put in the best place for the companies to make acquisitions – and the markets are much more diffuse than in the United States. For example, in the materials and equipment goods sector, 27 companies generate 50% of total sales, while in the United States this percentage is shared by a mere 16 companies.” The firm emphasizes that, over the last two years, the percentage of mergers and acquisitions among cyclical companies has been the greatest since the last recession, which suggests that this activity of concentration is already in progress.
Regarding the technology sector, Morgan Stanley sees corporate acquisitions as difficult, due to the fact that companies continue to be focused on plans for restructuring. In the banking sector, the firm expects problems “due to the high-level of market concentration.” But it sees some (attractive) options in Germany as well as among those banks that are specialized in the retail sector.
At the moment, the year has begun with a major upward push by the technology sector, which is facing better prospects regarding growth in demand for chips used in specific businesses such as mobile telephones. In fact, Goldman Sachs, the investment bank, recently raised to “attractive” its opinion regarding telecom operators, given prospects that the arrival of third-generation mobile phones will seduce European consumers.
In 2004, there will also be two political events of enormous importance for the continent: The expansion of the European Union to 25 countries, which will take effect starting on May 1; and elections to European Parliament, which will take place on June 13. There will also be legislative elections in France and general elections in Spain . Nevertheless, analysts who are optimistic about the omens don’t expect that these events will have too much influence on the way markets develop.