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Greece lightning

Investor confidence is understandably fragile as the market gauges the extent of the fallout from the credit crisis. Hopes hinge on resolving the financial dislocation inthe developed markets but it is just as important that the emerging economies of Eastern Europe and Asia continue to perform well.

As we enter the full-year reporting season for the banking sector, the results will bring some clarity in light of recent disruptions in the sector. Unfortunately, we will need to wait until 2007 annual reports are released in March to gain maximum disclosure on bank balance sheets. However, the ongoing issue of liquidity must be resolved before credit concerns and the risk of contagion start to abate.

Central banks have made a concerted effort to ease the liquidity gridlock by making cash available to the banking system. We are already seeing aggressive policy easing by the Federal Reserve but the European Central Bank continues to stay its hand as inflation remains sticky. The ECB is almost certainly of the view that the credit crisis is not so much about the cost of capital as the availability of capital. As the growth outlook deteriorates, we expect the ECB’s inflation fears to recede and rates to be cut by 0.75 per cent to 3.25 per cent, with the first cut in June.

The ongoing strength of the developing economies of Eastern Europe will be an important driver for the market. They proved quite resilient to the turbulence which afflicted developed markets in 2007. The economic fundamentals are mixed bag within the region but economies will benefit from increased FDI and the deployment of European Union subsidies.

Governments are investing in infrastructure and consumer confidence is strong. Companies with access to these markets should continue to prosper even if their domestic situation deteriorates.

We believe that Greece is a key play on this theme. Greek companies moved into many of these markets relatively early and stand to gain from their development.

Other countries we favour are Germany and, as a dark horse, France. In Germany, there is plenty of evidence that businesses are in good shape. Profit growth has picked up strongly, firms are awash with cash and the financial sector is running with a healthy surplus of around 5 per cent GDP. Unemployment is at its lowest level since 2000, although consumption has been slow to recover after January 2007’s VAT hike.

The next 24 months will be key for France. President Sarkozy has emerged as the torch-bearer for liberal reform in the developed world. The caveat is that he faces no small measure of public resistance. Last year displayed good underlying momentum in the French economy. The housing market was in good shape, unemployment has reached a 25 year-low and consumer debt is among the lowest in the eurozone. However, Germany and France will be hit by the credit crisis and the full effect remains to be seen.

Stock selection is paramount in this environment. Swip will seek to back areas such as long-term replacement/infrastructure and geographical trends, which are less dependent on movements in the market. Attractive valuation remains a key support for the overall European market, meaning there is scope for multiple expansion, but Swip also has a preference for healthy balance sheets which can support cash returns at a time when the risk/reward balance has deteriorated.

This year has all the marks of a bear market but you have to believe in policy failure for this to be genuinely the case. Nonetheless, exposure to defensive stocks should be part of any portfolio over the next 12 months. Swip’s European funds are playing this through an overweight exposure to utilities.

We think mergers and acquisitions will remain a theme, even though the credit squeeze has put the brakes on many deals. Balance sheet strength and potential for releverage will contribute to corporate activity. Business confidence – a necessary condition for M&A activity – is absent at the moment but we expect it to rebound towards the second half of the year.

Steven Maxwell is head of European equities at Scottish Widows Investment Partnership


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