Europe: A Continent of Change
IN PRINT ARCHIVE CIR Summer 2000
|Europe: A Continent of Change|
|by Olivier Rudigoz|
European equities have performed well over the past decade. Reasons behind this strong performance are well documented: falling interest rates, corporate restructuring, management focus on shareholder value, boom in the savings industry and the associated emergence of a retail equity culture.
Are all these factors reflected in the price? - No. Firstly, these supportive trends are still very much in place and gathering momentum. Secondly, new positive trends are emerging that will drive European equity markets further. In fact, Europe can very much be described as an environment of change.
Change is occurring at all levels: the macroeconomic level, the level of the capital markets, the companies' level and finally at the individual investors' level.
While the 1990s were a story of disinflation and budgetary discipline (trying to get ready for monetary union), these years were also years of very low economic growth, especially compared to the U.S. At last, growth is now picking up strongly in Europe: 1999 has been a good year and 2000, helped by the weakness of the Euro, looks to show an acceleration.
Unemployment, the curse of Europe throughout the decade, is falling significantly for the first time in years. In a context of low interest rates and benign inflation, it could even be argued that the so-called "new paradigm" has finally reached Europe and that this is not just a cyclical improvement. This view is supported by the fact that long-awaited structural changes--such as tax reform in Germany--are taking place.
European capital markets are also changing. Firstly, they remain largely underdeveloped compared to the U.S., as measured by the ratio of market capitalization to GDP, and have therefore still significant room for future growth. But more importantly, they are also undergoing qualitative changes.
Technology, as a sector, becomes increasingly available for investment in Europe. This is key, as the U.S. is too often regarded as the only place to invest in the industries of the future.
Indeed, there are even some industries--such as mobile telecommunications--where European firms are clear world leaders. In other areas, such as Internet penetration, Europe may have lagged behind, but is now catching up very quickly.
The attitude of major European companies towards investors and the capital markets is also evolving. Whereas in the last decade companies were mainly preoccupied with cost cutting and restructuring (in an admittedly difficult economic environment), they are now focusing on growth and profitability.
Again, there is still plenty of room for improvement compared to the U.S., which bodes well for the catch-up potential of European equity markets.
Moreover, managements are now paying real attention to their share price. This is firstly because stock option schemes are becoming more widespread. But this new attitude is also triggered by necessity, as evidenced by the sharp rise witnessed in mergers and acquisitions.
Europe is no longer the cozy and protected environment it has been for so many years. Cross-border and hostile bids have reached unprecedented record levels: indeed, the largest ever hostile bid took place in Europe this year when Vodafone of the U.K. successfully acquired Mannesmann of Germany. It has become crucial for companies to sustain a high valuation level if they want to remain independent.
In this respect, European companies are now paying new attention to one of their most precious resources: their share capital. Instead of frequently issuing new shares to finance projects whose profitability was sometimes questionable, they now focus on cash generation and increasingly buy back their own shares. This cannot be bad for the performance of European equity markets.
Lastly, European individual investors are changing their saving patterns. This is not a new phenomenon, but it is a very powerful and long lasting one which is gathering momentum. Europeans have realized they cannot rely on existing state controlled unfunded pension schemes. They are not waiting for a general reform of the European pension systems, which may prove elusive. They are already buying equities for their old age.
Again, as shown by the still low (compared to the U.S.) equity ownership levels prevailing in most European countries, there is room for further progress, which is bullish for European equity markets.
Additionally, the absolute low level of interest rates and the fact that governments, benefiting from lower budget deficits, are issuing far fewer bonds are strengthening the preference of investors for equities.
Therefore, beyond short-term valuation concerns in some sectors that may cause a pause in the performance of European equity markets, the long-term outlook remains extremely favourable.
Olivier Rudigoz is the Senior Fund Manager with Merrill Lynch Mercury Asset Management in London, England.