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Easy come, easy go

Volatility and periods of pronounced weakness have marked European equity markets following four years of strong gains. Banks were initially at the epicentre of these market moves but concerns about the economic outlook have begun to affect the wider market. We think that the root causes of this volatility – a higher risk premium and softer growth – are here to stay for the foreseeable future.

European equity markets appear attractively valued at about 12 times this year’s earnings. This is cheap compared with their own history, other developed markets and other asset classes. It implies that the market is already braced for lower earnings, which is healthy given the clouds on the economic horizon.

However, the risk is that the impact of leverage – be it financial or operational – is underestimated on the way down as much as it was on the way up. Investors still need to approach European equities very selectively. They need to be aware of areas of the market which are vulnerable to further earnings’ downgrades, given the economic headwinds of slowing growth, tighter credit and higher input costs.

Equity markets have moved on from the easy credit conditions which favoured companies with a high degree of financial leverage. Global growth, which gave a boost to companies with high operational leverage, is slowing appreciably. Banks, smaller companies and industrial cyclical stocks benefited most from those easier conditions. Now, the cost of risk has been pushed up to a more appropriate level. However, we believe there remain several attractive areas for investing this year which are much less affected by the current issues.

The key is to differentiate between those stocks whose earnings have ballooned as a result of cheap financing or thanks to the strong economic cycle and those with sustainable earnings’ prospects. After years of neglect, investors are likely to seek out companies with defensible earnings’ growth and conservative balance sheets. They will probably focus more on companies which let investors share the rewards in the form of attractive payout ratios and growing dividends.

Many continental European companies have increased dividend yields in recent years, rewarding their shareholders in much the same way as UK companies. Dividends make up 35 per cent of the total return generated by European equities over the long term. Fortunately, several market sectors offer visible earnings’ growth as well as attractive valuations and handsome dividend yields to boot.

The telecoms sector kicked off this process of rotation towards more defensive companies last summer. The sector was neglected for a long time after the dotcom bubble burst. After a good run last year, it has not delivered the returns this year which one may have expected from a sector offering low cyclicality and strong balance sheets. It now offers a very reasonable valuation and the second highest dividend yields after banks.

We believe the utility sector offers potential for dividend growth while healthcare and energy are previously unloved sectors which offer attractive earnings’ prospects and valuations.

We continue to be wary of banks. Aggressive actions by US policymakers have meant that financial meltdown has been avoided, so the recent bounce is understandable. However, capital shortages in the sector will continue to be addressed this year at the expense of shareholders in the form of rights issues and dividend cuts. There remains a question mark over banks’ medium-term earnings’ power in a world where leverage is being reined back.

After a number of years when investors could rely on a strong economic cycle and improving corporate profitability across the board, the time has come for greater discrimination and attention to finding business models that will stand up to tougher times. There is money to be made in European equities but be sure to know what you own.

Katharina Hoyland manages the Invesco Perpetual European equity income and European high-income funds

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