After investor confidence in European equity markets collapsed following the September 11 terrorist attacks, some cautious optimism is returning. The positive sentiment is reflected in recent bond market trends indicating an expected improvement in equities, as well as the relative outperformance of cyclical sectors within the market.
Reflecting that optimistic outlook, S&P Marketscope's model portfolio is overweight on stocks. Our key sector picks in the European S&P 350 index include consumer discretionary (areas such as hospitality, entertainment, retail, and autos), information technology, and materials. Our optimism is driven by four factors that we believe will lead markets higher.
The first is fiscal reform in Germany, Europe's biggest economy. In particular, the elimination of capital-gains taxes on corporations' sale of noncore holdings will help them put funds to more profitable uses. This will boost the return on equity, unlock hidden shareholder value, and encourage companies to increase the use of equity as a takeover currency. All of which will make investors view German stocks more favorably.
Moreover, S&P MMS expects the European Central Bank to cut rates two more times in the first three months next year -- by 25 basis points each. While the U.S. economy is likely to begin recovering in the first quarter of 2002, Europe isn't expected to follow suit until the third quarter.
Helping fuel that recovery is a pan-European easing of fiscal policy. The Continent's governments are expected to spend more to prop up sagging growth in 2002, and in combination with lower tax revenues, this will push budget deficits higher (although countries remain constrained by the 3% Maastricht deficit criteria).
Lastly, corporate earnings are expected to recover. Marketscope is already hearing positive comments from selected companies reporting a sequential increase in quarterly earnings for the first time since early 2000.
Analysts are increasingly confident that core earnings in 2003 will witness a sustained rebound. This stands in contrast to 2002's rise in core earnings, which will largely be driven by the low base in the year-earlier period. The market is already beginning to discount the shorter earnings outlook, focusing instead on 24-month earnings and valuations.
Here are S&P Marketscope's European sector picks.
Consumers' discretionary spending is driven primarily by their expectations about interest rates and employment trends. While interest rates have fallen significantly, employment worries remain as growth continues to soften. But on balance, we expect leading indicators such as the European Commission's consumer-confidence survey to turn positive in the coming months as bad employment news begins to ebb.
As such, we expect consumers to lead the recovery. Marketscope expects the consumer-discretionary sector to be one of the key outperformers in the coming 12 months.
Historically, the sector is closely correlated with long-term interest rates. Looking at the 1998-2000 growth cycle, the consumer-discretionary area rose 80% from its trough to its peak, with the bond market signaling on each occasion the turning points. We believe the bond market gave a buy signal -- when long-term rates stop sinking, indicating that bond investors are more optimistic about the economic outlook -- in early November and expect the sector to follow historical patterns and significantly outperform the market in the year ahead.
Within the sector, auto, retail, and consumer durables and apparel are expected to lead the recovery. Analysts' consensus is that these subsectors' earnings will grow 34%, 15%, and 16%, respectively, in 2002. Only in the case of autos is this rise related to a low base effect in the year-earlier period.
The overcapacity problems in the IT sector are now being effectively worked out through a combination of asset sales and obsolescence. While a large amount of excess capacity remains in the fixed-line telecom and high-tech manufacturing sector, companies have been writing down the value of these assets in recent months reflecting the lower-than-expected returns from these investments.
The semiconductor area is finally witnessing industry consolidation. Micron Technology's acquisition of Toshiba's DRAM production facilities and the possible withdrawal of other companies from the DRAM sector will help restore the demand and supply balance in the industry.
In the logic-chip sector, Taiwanese foundry producer UMC is already reporting modest increases in sequential monthly sales. Moreover, the Semiconductor Industry Assn. is cautiously optimistic on 2002 sales, forecasting a modest 6% increase following an expected 32% decline this year.
Banks are also becoming less risk averse toward the telecom-equipment sector. Ericsson recently sold $1.5 billion of vendor-financing loans to a consortium of banks, a deal that was unthinkable six months ago. Vendor financing, in combination with the balance-sheet strength of telecom-equipment makers, will be a key competitive advantage in persuading mobile-service providers to conclude infrastructure contracts for coming next-generation (3g) wireless networks.
We're positive on the IT hardware and equipment sector and more cautious on software services. For the former, last year's collapse in profits makes the earnings-per-share growth forecast for 2002 meaningless. Nevertheless, valuations have fallen significantly, and we expect selected companies in the sector to be favorably reappraised.
Like the consumer-discretionary sector, materials is a highly cyclical sector that we would expect to outperform as long-term interest rates move up.
Commodity prices are driven by global growth trends. While the past 18 months has witnessed a collapse in the prices of steel, pulp and paper, and petrochemicals such as ethylene, signs are emerging that the outlook is improving. Ethylene prices have bounced back in recent weeks, and investors have discounted an improvement in pulp and paper prices, with the subsector outperforming the headline index on a year-to-date basis.
With global growth trends improving, commodity prices are likely to be bottoming, and we expect to see a recovery in 2002. The one exception is oil, which we expect to lag behind the recovery in the economic cycle given the healthy supply situation.
The recovery in consumer spending will lead to a pick up in demand for a number of raw materials, which have seen significant price pressure downward over the past 18 months. A modest rise in auto sales from the estimated 15 million units in Europe this year will boost demand for steel, while an increase in household spending on consumer goods will boost aluminium and ethylene demand.
By Clive McDonnell, European Equity Strategist, S&P Marketscope