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World Cup runneth over

Germany and France have experienced their strongest economic growth in five years

Economic conditions in Europe are strong, as confirmed by recent EU data. Preliminary estimates of second-quarter GDP for the eurozone show growth of 0.9 per cent, outstripping the UK, Japan and a slowing US and representing the fastest rate of expansion in six years.

The German and French economies enjoyed a robust second quarter. Germany experienced its strongest growth in five years, assisted by the boost to consumer spending provided by hosting the World Cup. The French economy also advanced at its quickest rate in five years.

The influential German Ifo business climate survey reached a 15-year high in June although it fell back slightly in July on higher oil price and interest rate fears. French business confidence has been growing largely unchecked in 2006.

Our meetings with company management teams reveal an almost universally optimistic mood. Most are generating very high returns on capital and analysts are forecasting these returns to increase further.

After the correction in May and June, European stockmarkets have made up a good deal of lost ground. July saw a stream of healthy quarterly earnings figures reported in many industries, with the exception of technology and telecommunications. Company earnings estimates are looking robust although the rate of corporate earnings growth may slow from the high levels that have benefited the markets over the last year. Valuations, as measured by price/earnings ratios, continue to look attractive.

The overall European market is trading on just over 12 times forward earnings, which represents the low end of the price/earnings range over the past 10 years, but it should be noted that earnings might be at a cyclical high for many companies. Some areas of the market are trading at high valuations that are not particularly attractive relative to historical levels while other areas, such as the banking, oil and telecommunications sectors, are trading at lower multiples, closer to 10 times forward earnings, as concerns prevail as to whether earnings are sustainable in these industries.

Returns on capital employed are high although in many cases this is because of relatively short-term supply/demand imbalances brought about by past under-investment and not because the companies have changed fundamentally for the better. It is likely that the high returns will attract investment and increased competition will bring the returns down to normal levels, even without a slowdown in the global economy. With so many companies earning supernormal profits, it is rational that valuation multiples should be low.

It is worth remembering that with the projected return on equity at around 17 per cent for the European market over the next 12 months and a dividend payout ratio of around 40 per cent, earnings will have to grow by 10 per cent to keep the return on equity flat. This is pretty challenging.

Many companies are improving the quality of their business through restructuring, merger and acquisition activity or sensible investment. Many will continue to improve their returns and finding them will be the key task for fund managers.

Some concerns may exist over the short-term growth prospects of the US, the sustainability of China’s rapid economic expansion and the impact of soaring commodity prices but there is little suggestion that these factors will lead to more than a moderation of the global growth rate. European stockmarkets may struggle to match the returns seen since 2003 as further improvements in profitability for the market as a whole look unlikely. In this environment, stockpicking will be the key to generating performance.


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