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Comfort zone

European markets are poised to continue their strong performance throughout 2007.

European markets ended 2006 strongly and have got off to a decent start in 2007.

Behind strong performance has been a continued pick-up in earnings’ expectations. Profit forecasts were revised up by 7.6 per cent over the course of last year. Clearly, the pace of earnings’ upgrades is likely to slow but whether this will be dramatic depends increasingly on which path is taken by the global economy.

Last summer, a slowdown in the US housing market blew a chill wind across the economy although year-end data, including a pick-up in house sales and strong retail spending, suggest the decline may be bottoming out.

Data on this side of the Atlantic has painted an altogether rosier picture. Europe was able to indulge in a little schadenfreude as eurozone economic growth outpaced the US in the second and third quarters of 2006.

It would be premature to claim that Europe has finally managed to decouple from the US. A good proportion of its strong growth is due to a buoyant export market which still relies on Americans acting as consumers of last resort. Nonetheless, European exporters are well positioned and have generally focused on luxury goods, which are less price-sensitive, and capital goods, which are required by fast-growing developing markets.

In this regard, Germany has been a clear winner, in part because it has been somewhat more willing to adopt change and high levels of unemployment have been a restraining force on wage claims, making the country more competitive.

European equity markets have been reflecting the improvement in the region’s economic prospects. Over 2006, the FTSE World Europe ex UK Total Return index rose by 20.13 per cent in sterling terms (22.9 per cent in local currency) against a 1.57 per cent rise in the US S&P 500 Total Return index (15.79 per cent in local currency).

Investors could be forgiven for thinking that the strong performance of European markets may mean they are expensive. Earnings’ growth has been equally impressive, however, and European equities trade on a 12-month forward price/earnings ratio of just 13, which seems attractive in absolute terms and against historic averages.

Further support comes from corporate activity. Corporate borrowing costs may not be as cheap as previously but are still low, evidenced by the number of cash bids from private equity groups and companies seeking to arbitrage the differential between earnings’ yields and borrowing costs. There have been several cross-border deals such as E.ON’s bid for Endesa and Iberdola’s move on Scottish Power while the tie-up of Italian banks SanPaulo IMI and Banca Intesa marks another attempt to scale up to meet the challenges of globalisation.

Shareholders agitating for change are encouraging boards to be more efficient. Private equity groups such as Macquarie are forcing a more Anglo-Saxon model on to companies in the eurozone, reflected in the increasing willingness of European companies to return excess capital and raise dividends. Of course, there are still plenty of ill-disciplined companies in Europe and protection and politicking is an ever-present threat.

The French presidential election and German VAT rise are obstacles to surmount. In a welcome move, however, the European Central Bank did not follow the lead of the Bank of England and surprise markets with a January interest rate rise, suggesting it is wary of choking off the eurozone’s economic revival.

Ongoing takeover activity, relatively attractive valuations and stronger earnings’ growth mean that the outlook for European markets looks promising.

Companies within Europe are not homogeneous, however, and the most sensible strategy for investors is to ensure the companies they pick have strong business models. In time, attractively valued companies with proven management and strong cashflow will reward investors irrespective of the economic outlook.

Richard Pease manages the New Star European growth fund.

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