August 12, 2014 3:57 pm

European shares: down but not altogether out

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A summer squall – or the start of something bigger? European share markets have this week paused for breath after a torrid month in which prices were battered more than in the US. The European recovery story – which had driven equities sharply higher – has been left looking forlorn.

The FTSE Eurofirst 300 index has fallen 5.5 per cent since July 3 – over the same period the US S&P 500 dropped 2.5 per cent. Germany’s Dax was down more than 10 per cent – the usual definition of a market correction – before recovering a little this week. (Unlike other indices, the Dax includes dividend returns.) Portugal’s PSI 20 has fallen this year more than Russia’s Micex index.

“The progressive weakness of Europe is coming through, it is getting priced in,” warns Didier Saint-Georges, investment committee member at Carmignac.

European equities

The mood has clearly shifted since the start of the year, when optimism was high that economic growth would recover and countries such as Spain and Italy benefited as investors fled troubled emerging country markets. “You had a lot of froth in the periphery. Now the story has moved on,” says Mislav Matejka, equity strategist at JPMorgan.

The rally, however, may not necessarily have gone firmly into reverse. “This is a dip which is a long-awaited opportunity to buy, rather than become more scared,” argues Mr Matejka. “I don’t think Europe will outperform in the global context, but will Europe bounce back? Of course it will.”

One reason for optimism is that share prices have been hit by an exceptional confluence of bad news. Most obvious is escalating geopolitical tension – in the Middle East and over Ukraine. Russia’s retaliation against western sanctions could threaten European economies, particularly Germany’s.

But geopolitics may have just been the excuse for a sell-off. Worries have grown about European corporate earnings, and dark clouds are growing over economic growth prospects in the continent’s biggest economies.

Expectations about the outlook for European companies’ profits have seen the biggest monthly fall since at least 2001, according to Bank of America Merrill Lynch’s “fund manager survey” for August, released on Tuesday. “Global investors are losing faith in Europe,” says Manish Kabra, an investment strategist at the bank.

Italy, meanwhile, reported last week that it had fallen back into recession; GDP data for the rest of the eurozone on Thursday are expected to show growth stagnated in the second quarter. “That is disappointing investors buying ‘recovery’,” says Michel Leblanc, fund manager at Lombard Odier.

Against that background, a correction was inevitable given how high share prices had risen, argue some strategists. By July this year, the FTSE Eurofirst 300 index had risen 60 per cent from September 2011’s low.

As if the economic and earnings news was not enough, investors’ faith in the eurozone post-crisis rebound has been tested by fresh problems erupting among Europe’s weak banks. “The markets have been looking for a reason to sell. Geo-politics is one but a bigger one has to be the banks,” says Mouhammed Choukeir, chief investment officer at Kleinwort Benson.

Last week’s rescue of Portugal’s troubled Banco Espírito Santo added to anxieties ahead of the European Central Bank’s review of the financial health of the continent’s banks, due to be completed before November.

While midsized banks’ shares have fared worst, national champions have also been hit. Société Générale and Deutsche Bank have seen share price falls of 8.7 per cent and 4.5 per cent over the past month; overall, the shares of Europe’s biggest banks have underperformed the wider market by more than three percentage points so far this year.

“For a convincing return, we may have to wait until the AQR [asset quality review] is over – some investors want to wait to see if any skeletons come out of the closet,” says Nick Nelson, global equity strategist at UBS.

Huw van Steenis, banks analyst at Morgan Stanley, adds: “We think the AQR and bank stress tests could be the most important catalyst in the next three months – and prove more cathartic than the market currently fears.”

Once the ECB’s tests are finished, other factors could help European equities. As European and US economic prospects have diverged, the euro has weakened, which should help Europe’s exporters. Meanwhile, almost two-thirds of investors believe the ECB will be forced into “quantitative easing”, or US-style large-scale asset purchases – although the consensus has moved from action in the final quarter of this year to sometime in 2015, according to the BofA Merrill Lynch survey.

Yet even the possibility of a share price bounce back on a better news flow may not be enough to lift the prevailing gloom. Carmignac’s Mr Saint-Georges warns: “It doesn’t change the basic problem of Europe: it produces no growth.”

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