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Discomfort zone

Europe may struggle to match recent strong returns and investors should be cautious

European equity markets have enjoyed a stellar year, comfortably outpacing the Japanese, UK and US markets.

Every market has benefited from double-digit growth, with the Spanish market, buoyed by vigorous merger and acquisition activity, particularly in the utilities sector, having advanced by over 30 per cent in euro terms to the end of October.

Driving the impressive returns have been exceptionally strong company results. Companies are continuing to generate high levels of free cashflow and returns on equity remain very high. Frenzied M&A activity has been prevalent not just in Spain but across Europe.

Announced global M&A deals for the year to October 31 are up by 33 per cent year on year to roughly $2.9trn. Announced deals in Europe have soared by 38 per cent to $1.2trn and contributed to sharp gains in certain sectors, such as utilities which gained 34 per cent over this period. Excess global liquidity and the low risk premiums evident in the financial markets have supported this wave of corporate activity.

The European economy has provided a supportive macro environment for investors. Second-quarter data for the eurozone recorded GDP growth of 0.9 per cent with annual growth running at 2.7 per cent, the fastest rate since 2000. Unemployment in the single-currency region has moved down in 2006.

Underlining this economic robustness, recent data has revealed the German economy to be in generally good spirits. German business confidence, as measured by the Ifo business climate survey, rose in October while business sentiment has also showed recent improvement in France and Italy, aided by lower oil prices. Against this expansionary backdrop, the European Central Bank increased interest rates by 0.25 per cent to 3.25 per cent in October, the fifth time in the past 10 months it has raised rates although it kept rates on hold in November.

In contrast to the unbridled optimism that permeates European equity markets at present, we take a slightly more circumspect stance. Returns on equity may be at historic highs but our concern is that such heady returns may be unsustainable going forward. The European market is trading on a relatively low multiple, suggesting an attractive valuation, but its low price/earnings ratio is being distorted by the low multiples associated with the banks, oil and gas sectors that account for almost a third of the FTSE World Europe ex UK index. The remainder of the market appears relatively expensive, in our opinion.

A glance at the European small-cap market offers a possible cautionary tale in the making. With the value of European small-cap shares looking inflated relative to historical levels, we are mindful of the rollover of small-cap stocks in Japan and the underperformance of small caps in the US.

A note of caution should be sounded over the nature of some M&A deals, a few of which appear indicative of a somewhat manic desire for deal-doing by company management. This is not to say that consolidation in Europe does not offer good investment opportunities.

European stockmarkets may struggle to match the strong returns seen since 2003. In this environment, we believe stockpicking will be the key to generating performance. At Lazard, we will continue to focus on identifying companies that show sustainable or improving levels of financial productivity at attractive valuations.

Gabrielle Boyle manages the Lazard European alpha fund

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