Europe behaving badly

While volatility in European Equities is set to continue, opportunities are still there for the taking. Helen Brown explains

Sell in May and go away? Investors may think twice before following this old market adage this year. Sometimes referred to as the “Hallowe’en effect”, the theory goes that a winning strategy is to go long of stocks on 31st October and sell the positions, for a gain, on 1st May. There has been a body of academic research showing that, on average and across markets, the November to April period outperforms the months from May to October.

It’s the exception that proves the rule? It wouldn’t have served you well last year! The period from the 1st November to the end of April saw the MSCI Europe Index fall by over 17%, compared to a 0.8% increase in the market from May to October 2007 (Source: Bloomberg). But will this year be different?

The volatility experienced by equity markets since the autumn of last year has been quite unprecedented at least by recent standards; the only meaningful comparisons could be drawn only by historians of the financial markets looking back over decades. Looking back to 2007, it really was a year of two halves: the debt fuelled takeover boom of the early months quickly dissipated in August, when default rates on sub prime lending rose, leading banks to rein in their lending. Liquidity then drained out of the previously buoyant global credit market, swiftly leading to concerns of a global slump. This fear has remained at the forefront of investors’ minds ever since – and has been brought sharply into focus by a raft of huge writedowns by the investment banks, bailouts of the monoline insurers and rescue rights issues.

The most notable of these came from the French back Société Générale, where positions taken by a junior trader led to losses of Euro 4.9 billion, the largest trading loss in banking history (and, to put this into context, more than four times the amount that brought down Barings in 1995). To follow this, by the end of March, the turmoil had reached the very heart of the US financial system, as Bear Stearns, an 85 year old institution and the second biggest underwriter of mortgage backed bonds, sought emergency funding from the Federal Reserve following a severe cash crunch and was swiftly taken over by JP Morgan.

One of the most notable aspects of the recent market gyrations has been the steely resolve of the US Federal Reserve to buttress markets – and the sheer aggression of its actions – it has now cut rates six times since the crisis began
in August (to 2.25%) and, in its broadest use of its lending authority since the 1930s, allowed investment banks the same direct access to emergency funding as the commercial banks. Yet equally noteworthy has been the contrasting stance of the European Central Bank (ECB), which has continued to nail its colours very firmly to the anti-inflationary mast, keeping rates at a six year high of 4% in an attempt to curb rising consumer prices.

So what next for European equity markets in the face of all these conflicting signals? Unfortunately, the answer is far from obvious. While the Federal Reserve’s actions in loosening the US monetary belt can be seen as positive for equity markets worldwide, the US dollar has fallen to record lows against the euro while, concomitantly, the oil price has risen to a record (approaching $120 a barrel) as investors have rushed to buy commodities as a hedge against the weakening US currency. This has proved something of a “double whammy” for European exporters faced with falling receipts and higher fuel and raw materials costs. Cuts in UK interest rates and injections of liquidity from the Bank of England have not, as yet, been reflected in lower mortgage rates and increased lending.

And even the messages “from the ground” in the corporate sector are not uniformly in agreement. For example, while Deutsche Bank’s Josef Ackermann has said that he expects to see further writedowns from the global banking sector as the banks are forced to digest unrealised losses linked to the sub prime mortgage crisis, WPP chief Sir Martin Sorrell has announced record 2007 profits and declared that the US will only see a slowdown in 2009, not a recession.

What can we say with any certainty? At this juncture, probably only that the current uncertainty is likely to continue, at least in the short term, as recessionary fears continue to loom large and the prospect of relief from cuts in European interest rates is clouded by the continued spectre of inflation. The consumer cannot be immune to this, as the combination of rising food and fuel prices, together with fears of a housing slump and the loss of the “wealth effect” that comes along with the sustained boom in house prices that we have enjoyed in recent years, is likely to act as a significant dampener to consumer spending over the coming months. The strong euro and the lack of rate cuts from the ECB suggest that the corporate sector will see slower growth in the second half of 2008. And, more generally, the current flight from risk is clearly a significant potential block to growth; rising risk premia may well dampen appetites for exposure to European equities.

Equally, however, there are still reasons to be positive. European growth has proved, at least thus far, to be relatively resilient. While there has been much focus on economies such as the UK and Spain, which have seen large increases in property prices and household indebtedness, there has been less comment about other large European countries, such as Germany, France and Italy, which still have high household savings rates and sound balance sheets. Europe’s corporate cash flows and balance sheets also remain in a position of relative strength, as is evidenced by the small resurgence in M&A activity from the corporate sector seen at the start of this year. Private equity markets too, may not be moribund – and certainly, are unlikely to remain closed forever, given the huge sums raised at the height of the boom which currently remain largely uninvested.

While the “glory days” of easily available cheap debt have clearly passed, the traditional option of mezzanine finance may open up again to provide attractive opportunities for these funds following the indiscriminate sell off
in the public markets. Similarly, while corporate cash flows remain strong, a return to more “normal” conditions in the private arena may prove to be beneficial for the corporate sector over a longer term horizon – and potentially provide options for growth by acquisition once more, based on business synergies rather than purely on debt capacity.
Taking a broader view, it is important to remember that Europe leads the world in many areas: pharmaceuticals and environmental technology to name but a few. And while the stellar growth of China and other Eastern economies is seen as a threat by some, it also offers opportunities – and not only in terms of direct export growth, as the recent purchase by the Chinese government of a large stake in Rio Tinto (to ensure its ongoing supply of raw materials) implies. So – selling in May and going away may not be a winning strategy again this year in the European equity markets. While volatility is almost certainly set to continue, this is likely to throw up as many opportunities as challenges.

Written by Helen Brown, Portfolio Manager, International Equities, Northern Trust Global Investments