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In Europe, a Tale of Two Sectors

By Clive McDonnell S&P's European Investment Policy committee (IPC) decided to adjust its asset-allocation recommendations on Oct. 5. We raised our recommendation for the health-care sector to overweight, from neutral, and lowered our recommendation for the financials to underweight, from neutral.

Why the changes? They reflect changing industry group dynamics in pharmaceuticals and updated economic trends for banks.

IN THE PINK. The upgrade to the recommended weighting in the health-care sector reflects a sustained improvement in the prospects for pharmaceuticals. Greater clarity about the pipeline of drugs from companies such as AstraZeneca (AZN) and GlaxoSmithKline (GSK) has led our analyst to raise his assessment of the sector's outlook.

Earnings growth for the health-care sector is an attractive 23% this year, dropping to 13% next. Both growth rates are higher than the overall market. Sector valuations at 19 times 2005 earnings represent a premium to the market, but, with a p-e-to-growth (PEG) ratio of less than 1, this is not necessarily expensive when framed against earnings growth forecasts.

The decision to downgrade the financials sector is a reflection of the negative outlook for British banks. They represent almost half the industry group's market cap, and the group is the largest in the sector.

TAX DANGERS.We would prefer to maintain a neutral recommendation on European banks and financials and an underweight for British banks, but such flexibility does not exist for us. Investors wishing to exploit a strategy that favors European banks over British ones could do so, as it is easy to execute.

Our main concern relates to the weakness in the British economy. Consumer spending has slowed, and the property market is weak. Moreover, the risk of tax increases in the budget cannot be ruled out. Our analyst has identified three additional issues that he views as a drag on British banks: 1) investigations covering loan insurance fees and small and midsize business current-account interest rates, 2) provisioning for unsecured lending, and 3) risk of cuts to credit-card interchange fees.

We remain overweight on equities in our model portfolio and are retaining our yearend and mid-2006 index targets for the S&P Europe 350, which implies a 3% and 12% upside, respectively.

McDonnell is European equity strategist for Standard & Poor's

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