David White
Is the Euro-zone equities market being driven by interest rates or by earnings? The evidence is that successive interest rate cuts by the European Central Bank have failed to turn the Euro-zone equity market. Euro-zone rates have fallen from 4.75% to 2.0% since May 2001, yet over the same period, the DJ Stoxx index has fallen 42%.
For their part, Euro-zone equity managers believe that micro rather than macro factors are behind the recovery in equities and that the most important of these factors is earnings.
Maria Polycarpou, fund manager in the UK and European equities small and mid caps team at Barings Asset Management, attributes the good results in the first quarter of the year to the stabilisation of earnings. “The reason we have had this stabilisation is not because interest rate cuts are producing an economic turnaround, but because companies have been restructuring and cutting costs.”
Sectors that have performed best are those that have taken a battering over the past two and half years, she says. “In the media sector companies have reported earnings growth due to restructuring. This combined with cost cutting has led to an expansion in margins and some good results from specific stocks.”
Earnings have stabilised or even improved in software companies, telecoms and banks. “In industrials the picture is more varied but the companies that have showed resilience have been the companies that have been taking the costs out and you can see it in their results. We are seeing order books stabilising.”
Small caps have outperformed large caps in the year to date, she points out. “The outperformance started when markets started falling at the beginning of 2000. The reasons for this is again earnings-driven. The earnings growth profile has been higher in the small cap area than in large caps. The forecast for 2003 is that small cap as an asset class is expected to have higher earnings growth than large caps.”
Small caps outperformed because, unlike large caps, they did not overspend on over-priced acquisitions in the late 1990s.
Surprisingly, the outperformance has continued through the rally in equities. “We thought that in a rally these small caps would be left behind, but this hasn’t actually happened. If you look at performance of small caps in the year to date they have outperformed. The reason for this may be that they have more resilient earnings.”
Earnings are also driving allocations to large caps. Stephen White, head of continental European equities at F&C, says he is encouraged by the relatively small number of earnings downgrades among European companies. Earnings upgrades and encouraging first quarter results have encouraged him to go overweight in banks. “Loan loss provisions have not risen too far, and the benefits of cost cutting drives are coming through,” he says.
White is underweight in sectors where earnings are vulnerable to exchange rates. “We have a cautious outlook for pharmaceuticals partly be-cause earnings are vulnerable to overseas currency movements, particularly declines in the US dollar versus the euro.”
The effects of the fall in the dollar against the euro on companies’ prospects may have been underestimated, says David Dicks, co-head of European equities at Goldman Sachs Asset Management. “The euro’s strength is a major issue for companies. It has been factored in to share prices but there seems to have been something of a lag this time. People may have been distracted by Iraq and bad economic data and didn’t really think about the implications of the dollar as quickly and as efficiently as they usually do.”
The effect of currency movements on future earnings could slow the equity rally in the Euro-zone. Because the equity market attaches such importance to earnings, it follows that earnings must improve further if investors are to stay in equities. The European equity strategy team at Citigroup Smith Barney says the current consensus is that investors will need to see evidence of improved earnings before the equity market can progress any further: “This should suggest that investors move back into cash until such evidence emerges. However, we also worry that the easy option may be the wrong option. The benign reaction to significant negative news announcements from IBM and Daimler Chrysler is building a suspicion that the market may be starting to change its mood. Could it be that, just as most equity investors have given up on the ability of interest rate cuts to turn equity markets, they are starting to do exactly that?”
The Citigroup team suggest that the equity market may be moving from an earnings-driven to interest rate-driven phase. This would have significant implications for the market outlook and the appropriate investment strategy: “If low interest rates rather than weak earnings start to be the key dynamic then it is too early to switch out of equities back into cash.”
The strategy implications of a shift towards a more rate-driven market are profound, they say. “Equity and bond markets can still perform well while central banks continue to pump out cheap liquidity. The key call is to stay long of financial assets and out of cash.”
At a stock and sector level, they say, investors should resist the temptation to rotate out of the more cyclical stocks and sectors back towards the defensives. Within sectors, investors should resist the temptation to switch back towards those stocks with more stable balance sheets and earnings profiles.
“Our strategy is weighted towards a rate-driven view. For now, we resist the temptation to turn cautious on equities and adopt a more defensive sector strategy. In a more rate-driven market, those investors waiting for earnings to turn run the risk of being too late.”

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