No More "Easy Money" in Europe


By Alex Halperin The impressive gains made by major European indexes this year have topped those made on the other side of the Atlantic. But they won't continue through 2006, predicts Clive McDonnell, Standard & Poor's European equity strategist, who says markets will suffer because of increases in benchmark bond yields and interest rates as the global economy heads for a slowdown in 2007.

In his 2006 market preview, McDonnell and his London-based team of analysts forecast a 7% fall in the S&P Europe 350 index for the year. What's behind his bearish view? BusinessWeek Online reporter Alex Halperin recently spoke with McDonnell about his investing outlook for the coming year. McDonnell also addressed the "futility" of media acquisitions by telecom outfits, why telecom equipment manufacturers stand to gain from the telecom wars, and why strong growth in 2006 won't help the market. Edited excerpts from their conversation follow.

Your report is titled The End of Easy Money. It's been a pretty strong year for the major European indexes. Why is this going to end?

I think there are two primary reasons for it. One is a forecast rise in risk aversion amongst investors, and the second is the coordinated global tightening of monetary policy that we're going to see in 2006. It's the first time in 20 years that we've seen this type of policy, and it definitely will drain a lot of the excess liquidity that has been buoying markets over the past number of years.

You say investors are "too sanguine." Why?

They have benefited from the effects of ultra-low interest rates, and the consensus does not believe that rates are going to rise dramatically going forward. I don't see long-term rates going to 5% or 6%. However, that doesn't mean the type of move in rates that we're forecasting is insubstantial.

For the short end of the curve we're in line with consensus [forecasts]. We believe that European Central Bank rates will go from 2% to 2.5%, and certainly that's not sufficient to derail a lot of the euphoria that's been in markets, a lot of the M&A activity that was seen, and it certainly doesn't alter that dramatically the threshold rate in terms of the cost of capital.

However, nobody funds themselves at the short end. If we switch to the long end [of the yield curve] the picture is very different. Where we differ from the consensus is that the consensus is not as bearish on spreads [between long- and short-term rates]. Also in terms of yields, they see them rising just about 20 basis points from where we are at the moment, from 3.5% to 3.7%. But if the consensus is right, I think its fairly optimistic to assume we're only going to see a rise of only 20 basis points in long-term rates.

A lot of investors are getting really excited, but the reality is that investors remain surprisingly risk averse. On the face of it, that's at odds with the 20% rise in equity markets this year in Europe, but if we think about it valuations are unchanged from 12 months ago -- the reason being that earnings have risen exactly in line with the markets. We haven't seen any rerating [of valuations] in European equities and I've been surprised by that.

I've been fairly optimistic on the market up to this point, but one puzzle is...why haven't investors -- if they're really bullish on the outlook for Europe -- why not rerate the market, outside the energy sector. We've seen valuations climb in selected sectors, but they haven't broken out of their range, stripping out the bubble years. If investors are so bullish about the outlook, then that's at odds with the fact that they're not willing to pay valuations justifying that.

One thing you suggested is that Germany is going to lead growth on the Continent. How is that going to affect its neighbors?

It will have a positive effect on its neighbors. But I think the real story is more what's going on in the global economy that's helping German exports at the moment. Certainly, the weak euro is a positive. Also, the pickup in investment that we've seen in Asia and also in the U.S. has benefited a lot of the German engineering and technology companies.

Our issue is not about growth next year. Growth next year will be great, and earnings will be respectable. Our beef is the fact that investors already discounted that. Investors, as we move into next year, are now going to be focused on beyond 2006, and that's where we think there are risks to the growth story. As rates rise and we see a natural slowdown, that is what investors are going to focus on, and that should drag rates lower.

Some investors think that's a very short cycle. Last year we saw a bit of a pickup in growth. 2006 will be a peak and then we roll over in 2007, but that's been a feature of the Eurozone since 1999. Growth's been fueled by net exports.

There's no domestic demand. So in the absence of domestic demand that's what happens, growth cycles are very short. If we were to see a revival in domestic demand than that absolutely would lengthen the cycle, but there's no evidence whatsoever that we're seeing a sustained pickup in consumer spending in the euro zone.

Are there any sectors about which you're bullish?

We do have sectors overweight, particularly IT, consumer staples, and the health-care sector.

The report mentioned that IT and telecom manufacturers are going to benefit from feuds in the actual sectors. Can you give an example of how that might play out?

If you look at the big investment plans for the big telecom companies here in Europe, they seem to be focusing on the fixed line side. British Telecom (BT) has a 12 billion [euro] investment over the next five years.

As the old legacy players try to address the erosion of their fixed-line revenues they have to invest once again, and that's a reverse in what we've seen over the past five years where the emphasis has been on reducing investment -- and I would emphasize fixed line as opposed to mobile in that context.

In mobile, are the telecoms going to be more fractious?

We could see some more M&A activity, but I believe the market doesn't really value growth via acquisitions for that sector. The sector is not growing, and buying competitors is one way to expand earnings, but it's only going to be a short term fillip. It doesn't get away from the fact that longer-term revenue trends are for growth more in line with gross economic growth. We've seen the surge and now we're moving back to more normalized growth trends.

Elsewhere, does S&P expect M&A to continue to be a major focus in 2006?

M&A will continue to be a factor for the market but given [tightening fiscal policy] the implication is that this year's the peak. It's inconsistent to believe we'll see a further increase in M&A next year if we have already passed the high or the low point in the credit cycle, depending on which way you want to look at it.

Are there any sectors in particular to look out for in terms of M&A activity?

In the utilities sector you're likely to see it -- that's our core view. The market is very excited about the telecoms sector, but our own analysts believe there is little reason why telecom companies need to own media companies. Rather, what they need is access to content, and that does not require ownership of the companies.

In actual fact the reverse is taking place. Telefonica (TEF) acquired [Dutch content provider] Endemol a number of years ago and Telefonica has actually divested a portion of its stake in that company at a massive loss.

So you think it's just hype?

The view of our analysts is that the market is more excited about it than the reality. A lot of the content providers that these companies should be looking at tend to be unlisted. If you look in the media sector, the makeup is professional publishers, advertising companies, and broadcasters.

Once you actually start to break it down in the market, the content within the media sector is amalgamated with a number of other different types of business lines. We don't see the justification for why they would be interested in acquiring them. Acquiring the rights? Absolutely, but you don't need to own the company to get access to the rights.

Halperin is a reporter for BusinessWeek Online in New York


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