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14 October 2002

Investment Week
Europe: Fund Manager's Comment

Euroland growth estimates cut

The springtime improvements in Euroland economic indicators proved short-lived and European Commission growth estimates for the second half of 2002 have been cut sharply.

Even its suggestion of 1% GDP growth may prove optimistic given the particularly weak performance of Germany, the region's largest economy.

Here the key IFO confidence indicator has fallen for four months in a row, retail sales are lower and unemployment is back over the four million level.

With declining US growth, a strengthening euro and the effects of a 30% oil price rise since last Autumn, business activity and consumer demand are fragile and tax takes below forecast.

Though consumers in the US and UK have sustained a reasonable level of economic growth, this has been lacking in Europe for some time as an ageing population saves for retirement.

The political swing to the right in France was not emulated in Germany's recent elections so necessary structural reforms are less likely.

Meanwhile, weakening growth leaves little room for budgetary manoeuvre as deficits threaten to exceed the Euro Stability Pact limits and were exacerbated by the costs of the recent widespread flooding in Germany and Eastern Europe.

A stronger than anticipated US recovery and a more accommodating stance by the European Central Bank are required to stave off recessionary threats.

There are some signs that the ECB is beginning to understand the need for lower interest rates.

These uncertainties together with the effect of US financial scandals, a severe downrating of analysts' corporate earnings forecasts and evidence of forced selling of equities by financial institutions resulted in a 20% market collapse during July.

With a forward valuations at that point indicating a 2003 P/E of around 14 times, some limited demand for equities, in a low-volume holiday period, spurred a 16% rally which has now been more than reversed.

The second-quarter European corporate reporting season was disappointing with banks and insurers significantly increasing provisions while Latin American-related losses, exceptional items and accounting changes are manifest.

Meantime the renewed threat of terrorist activity and a potential Middle-East war is scaring investors out of the ordinary shares they espoused in the late 1990s and back into bonds and cash. This has implications for Europe's longer-term equity culture.

A lot of this bad news is already discounted in share prices.

While markets made new lows during September, the prospect of some economic improvement in 2003 combined with more realistic valuations than for some years, plus monetary stimulation, could provide a base from which equities can advance.

Our portfolio emphasis is towards France and Spain where we see faster growth and we favour cyclical consumer goods and services together with selected financials, chiefly consumer banks.

Construction activity remains relatively strong, particularly in Spain, with French cement company, Lafarge, also a beneficiary of strengthening emerging market activity in the Asia/Pacific region.

Elsewhere food producers, oil and gas and the auto sector are likely to maintain their recent outperformance.

Earnings uncertainties, share price volatility and the threat of new equity supply to rebuild ravaged balance sheets, notably in the telecom and insurance sectors, underline the necessity of adhering to proven managements and quality franchises.

Michael Dick is senior investment manager Europe for The Scottish Investment Trust
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