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Europa and the bull

We are only halfway through 2009 and what a year it is proving to be. No sooner had investors dusted themselves off after one of the worst-ever starts for European equities than they were riding the wave of one of the strongest-ever post-bear-market rallies.

Since their lows in early March, European equities have returned 35 per cent (to July 21), as risk appetite – absent for months – was resurgent. But this advance has come from a comparatively low base and most of the good news occurred during April and May. Equity markets took a step back in June as investors began to contemplate when and how the global economy is going to recover.

The jubilation over recent months probably owes more to a relief that total meltdown was avoided rather than concrete evidence that a recovery is under way. The issue now is whether this is a brief setback in a longer-term rally, driven by a bout of profit-taking, or the start of a broad retreat.

Economic data is moderately supportive but everything hangs on the efficacy of the extraordinary policy reaction by governments and central banks. Not surprisingly, the lagging indicators are weak – first-quarter eurozone GDP numbers were not for the faint-hearted, with the economy contracting by 2.5 per cent.

Forward-looking indicators, however, have been slightly more encouraging.

The European Commission’s index for economic sentiment rose for the third month in a row in June but the survey was not without its worrying elements, with concerns about unemployment continuing to loom large.

Since March, the market has priced out economic and financial ruin but it has not yet priced in a full recovery.

Sustainable equity gains will be dependent on signs of a distinct economic upturn and a return to profit growth. But while the GDP downgrade cycle may be over, recovery is far from assured and, should it come, it is likely to be mild.

As for earnings, the downgrade cycle continues but at a considerably diminished pace. The second half of the year is likely to see earnings bottom out, with 2010 producing growth, due in part to tighter cost controls by many companies.

Notwithstanding the anaemic outlook for economic recovery, at this juncture, the medium-term earnings’ picture is supportive of further gains in European equities.

The second-quarter reporting season is already pointing to concrete signs of improvement. News from corporate America – where heavyweights such as Goldman Sachs, Intel, and JP Morgan Chase have reported excellent results – has emboldened the bulls on both sides of the Atlantic.

Against this backdrop, we have been selectively moving into a number of early cyclical stocks, such as Adecco, the world’s biggest recruitment and human resources services company. The group’s valuation was extremely attractive and therefore represents a bargain, given the upside potential for the stock.

In addition, we have been moving back into the building sector, with a preference for companies that have a strong presence in the US market.

The world’s biggest economy led the world into recession and we believe it will be at the vanguard of the recovery. President Obama’s comprehensive stimulus package, which has a sizeable component dedicated to infrastructure projects, should also benefit a number of companies. The telecoms sector is also throwing up a number of interesting names. During the recent rally, a number companies lagged the wider market and we now believe they are primed to advance over the coming months.

Firms such as Telefonica, KPN, France Telecom, and Deutsche Telekom look cheap on a price/earnings’ basis. These companies also pay sizeable dividends – an extremely attractive attribute in the current record-low interest rate environment – and generate strong cashflows.

It is never easy to predict where equity markets might be headed in the coming months but in the current climate it is proving particularly tricky. Volatility remains palpable but as we enter the second half of the year, we believe there are grounds for cautious optimism.



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