Bright spots may yet cloud over

European stockmarkets have been attracting renewed investor interest as the debt crisis moves towards resolution. The recovery across ‘core Europe’ last year created a clear bifurcation between the solid – exciting even – growth of core countries such as Germany and the Nordics, and the problems of the peripherals such as Ireland, Greece and Portugal.

“Europe has been a continent of two halves, with the North performing much more strongly than the South,” says Simon Miles, head of Merrill Lynch Portfolio Managers, EMEA.

“We still think that large cap northern European stocks are attractive, particularly over the short to medium-term. Corporations around the world are building up large cash balances, some of which will end up in capital expenditure – and this will benefit the big European industrials and IT companies.”

However, Europe still has an image problem, a hangover from its socialist roots, which has been exacerbated in the last few years by the euro debt and Greek crises. Investors are by and large underweight the region, but that is beginning to change. European equity funds have seen steady inflows in 2011 as sentiment on the euro improves and governments make progress on their debt problems.

The optimism is largely driven by the North’s strong earnings growth; around 15 per cent earnings growth per share is expected this year, as revenues and margins strengthen. “We are seeing a different growth pattern in Europe than we have had for many years,” says Tim Stevenson, director of pan European equities at Henderson. “Growth has been slow in Europe but we expect a square-root-shaped recovery, before it then levels off.”

European equity markets are on low valuations, and offer handsome dividend yields. The average European stock is on a PE of 11 X 2011 earnings, which is at the low end of the historical range and cheap compared for example with Japan on 14 and the US on 13.5. The potential upside in valuations could therefore be underestimated, argues Nigel Bolton, head of BlackRock’s European equities team.

One attraction is that European companies have been forced to trim the fat over the last few years, and many are now lean businesses with strong cashflows and healthy balance sheets. These growing cash piles could be put to good use raising dividends, buying back shares and in making acquisitions.

Cesar Perez, chief investment strategist at JP Morgan Private Bank, points out that only 1 per cent of market cap is currently involved in potential M&A activity, and there is huge potential for that to grow, and for deals between businesses in the developed and emerging worlds.

“These markets have not been the place for growth stocks for years, and therefore the differential between stock multiples is at its lowest level because investors have previously not wanted to pay a premium for growth. Looking ahead, we think this will change and companies that are cash-rich and don’t have much growth potential will pay a high multiple for growth.”

Some of the cash will also be channelled back into Capex and this could be underestimated, adds Mr Bolton, who thinks investors have underestimated demand for replacement, particularly in sectors such as transport and travel.

Consumers are enjoying their share of this prosperity, and fund managers therefore favour luxury goods and other discretionary spending sectors such as cars. “Rising real asset prices are creating a wealth effect in the core economies, which is very good for the consumer,” says Alexander Scurlock, manager of Fidelity’s European Growth fund. “We think these structural trends could endure for three to five years.”

Germany out in front

Leading the way is Germany, where last year gross domestic product jumped 3.6 per cent, the most since unification, according to the Federal Statistics Office, and unemployment fell to levels not seen in 18 years. German plant and machinery orders are up over 40 per cent year on year, according to the VDMA machine makers’ association.

The German economy depends heavily on demand from emerging markets, as exports account for more than one-third of national output. The weaker euro has contributed to the North’s export success.

However, history may judge the first quarter of 2011 as an inflection point because while strong growth in the core is forecast to continue for the rest of this year, further out there is concern about the sustainability of the growth in emerging economies, and any slowdown in global demand will hurt European exporters. A minority of fund managers are therefore switching away from export-reliant sectors.

Another issue now becoming visible is the impact of higher commodity prices. “A number of sectors/stocks are exposed to higher input prices, such as soft commodities for food manufacturers or higher raw material costs affecting a variety of sectors, such as industrial goods, autos and chemicals,” says Alexandra Annecke, fund manager at Union Investment. “While there may be some pass through to customers, this depends on individual pricing power and will come with a lag pressuring margins in the meantime. This is not fully captured by analyst forecasts or market expectations.”

This inflationary pressure has been created by the monetary policy of central governments. “My view is that expectations for the emerging markets are somewhat over inflated and the market is not taking seriously what the policymakers are saying, specifically the interest rates increase,” says Marco Mencini, head of European equity research at Pioneer Investments. “We still anticipate solid growth in this region but some sort of disappointment cannot be ruled out.”

He predicts that investors will begin to move away from companies with exposure to emerging markets in the short-term, and the market will continue to be driven by macro events such as sovereign risks and debt concerns which will provide buying opportunities of high-quality companies.

“If emerging markets are not able to provide any more positive surprises, then investors will be forced to reposition their portfolios,” says Mr Mencini. Already some professional investors have closed their short positions to banks and the energy sector, but time and confidence will be required for this U-turn to take shape.

Some European equity fund managers are now beginning to diversify out of their overweight positions in cyclical stocks, and looking at southern Europe for individual opportunities.

“We remain positive on the core on the basis that demand is strong, and there is tension in the supply chain, particularly in the auto and semi-conductors sectors,” says Nicolas Walewski, fund manager at Alken European Opportunities. He points out that Peugeot, for example, is particularly cheap, trading at 0.1 X sales or one tenth of annual sales, when it should be 0.2 or 0.3. He also likes the steel sector and is buying Arcelor. However, Mr Walewski concedes, “longer-term visibility is poor because the sovereign risk position has not changed, and there are huge imbalances in emerging markets.”

Sovereign crisis

Views on financials are split, largely depending on whether the sovereign crisis can be resolved without drastic restructuring. The recent rally in banks could be a technical adjustment rather than a real turning point.

“The key issue facing Europe is clearly the enormous debt burden in the peripheral countries,” says Robert Farago, head of asset allocation at Schroders Private Bank. “A successful outcome will ultimately require a combination of recognising the extent of the problem, restructuring government debt, recapitalising banking sectors and strengthening fiscal coordination. This presents a significant political challenge and further crises are likely. However, this is not new news. The current pessimism in markets means that any steps in the right direction will boost confidence in the euro.”

The performance of the banking sector acts as a barometer of progress, and there is scope to be surprised in both directions, says Mr Farago. “From a more fundamental perspective, however, we are cautious on the banking sector. Indeed, we measure upside to fair value for the overall sector in single digits. The last two times this has occurred, a significant correction followed soon after.”

The consensus is that the euro crisis will not be allowed to deepen significantly, however.

“This is an opportunity for the euro project to turn the page and address the structural issues in the market, just as Asian emerging markets did following their 1997-98 crisis,” says Thanos Papasavvas, head of currency management at Investec Asset Management.

“The market is focusing on the economic situation, which is worrying for smaller European countries, but policymakers will do whatever is necessary to maintain the project. It has been 50 years in the making, and its roots are more political than economic.”

Stockpicking key to success in european market

Investors looking to benefit from the European recovery are being urged to take a careful stockpicking approach.

“We view Europe as a market of stocks rather than a stock market,” says Andreas Feller, head of investment advisory at Bank Julius Baer & Co in Zurich. “So stockpicking is key. We are focusing on cyclical stocks with strong growth prospects and limited risk of missing analyst expectations, and we are recommending regular re-assessment and profit taking following the recent market uptrend.”

Mr Feller likes high conviction funds Oddo Avernir Europe and Investec Energy, which invests in the stocks of exploration, production and distribution companies. He also supports BGF Swiss Small & Midcap Opportunities Fund and BGF World Mining.

A common theme is increasing allocation to energy stocks. “The oil price was a laggard in the commodity rally last year,” says Robert Farago, head of asset allocation at Schroder Private Bank. “Inventories remain high but the overhang from floating inventories has gone. We expect growth in the emerging world to remain robust and activity in the US to pick up, leading to strong global activity overall. This should support prices at these higher levels and provides scope for upside surprise.”

Energy equities offer catch-up potential, add an element of protection against inflation within portfolios and avoids the ‘contango’ that has meant energy futures have moved sideways over 18 months despite oil prices more than doubling, he says. This has recently reversed for Brent futures but persists for West Texas intermediate. “From a longer-term perspective, we are now facing an era of tough oil – oil that is difficult to extract, or comes from countries that are difficult to work with. This argues for a more strategic allocation to the sector in the years ahead.”

Europe is also prized for its strong value opportunities. “In today’s relative value trade environment, everyone seems to be looking for the ‘less worse’ asset class, and they are willing to pay high prices for meagre returns and significant risk as long as the shunned asset classes are worse,” says Paul Marson, chief investment officer at Lombard Odier Private Banking. “We would rather invest in real structural value than playing the dangerous bubble games, and this value is to be found in European markets.

“Regional selection accounts for about 70 per cent of equity portfolio returns through time,” he says. “Valuation is one of the main drivers of our preferences. Our most preferred European countries are Italy, Germany and France, based on various valuation measures such as trend multiples, risk premia, market cap to GDP.”

France has recently ousted Spain from the top five due to the latter’s weaker growth indicators and still mediocre momentum. The UK is sixth.

Several wealth managers have also recommended German exchange traded funds such MDAX ETF for exposure to this strongest economy of Europe with its overweight to the capital goods sector, and a high proportion of exports to emerging markets.

Alexander Scurlock, Fidelity