Europe offers same potential as US market

Serious Money: European equities are simply becoming an extension of Wall Street, writes Chris John.

With more fanfare than it deserved, the UK equity market recently touched a two-year high. Bullish headlines also accompanied rallies in many European markets as well as the US.

Mainstream equities have been on a bit of a roll since they touched their lows for 2004 in the first half of August. Indeed, the charts for the past six months or so send a strong picture of stock markets easily able to shrug off earlier gloom and despondency about high oil prices.

While the recent rally started with a retreat of oil prices from their highs, it has developed a momentum of its own. Bullish sentiment has not been dented by deteriorating news from Iraq, higher interest rates ahead, one or two high-profile profit warnings on both sides of the Atlantic and a partial reversal of those earlier oil price declines.

In one sense, the market has been helped by lower bond yields: traditionally, when long-term interest rates fall they are seen as lending valuation support to stocks. But lower bond yields are a two-edged sword: if they signify reduced expectations about economic growth that can hardly be good news for stocks. Indeed, there are plenty of doom merchants arguing that bonds have got it right and equities are off on one of their periodic flights of fancy.

On this line of reasoning, when markets wake up to the reality of much lower growth ahead, bonds will continue to rally and stocks will take fright. But this is also too extreme a reaction: the right way to think about recent market movements is that we have been stuck in a trading range for some time and the top of that range is now being tested. While I stick with my previously expressed views that equities will register small positive gains this year, I would caution against reading too much into recent market strength.

One of the reasons why the recent rally should not be taken too seriously is that, in a longer-term context, it hardly registers on the charts. Most markets are still a lot lower than they were five years ago and many are struggling to break above levels that were first seen in 1997 or 1998. It will be many years - perhaps a decade or more - before we see markets regain the heights they achieved during the first half of 2000.

Of much more interest is the emerging pattern of global returns. Ignoring, for a moment, the malign influence of currencies, it is always instructive to ask whether Europe or the US has offered the best home for our money.

Over the longer term - the past 10 years - the US wins hands down. Over the past couple of years it is a closer run thing: the past 12 months have actually seen German equities - long described as the basket case of European markets - outperform their US counterparts. Over the short and longer term, UK equities are underperforming their US and German competitors.

Why is Germany doing so well when all we see are headlines about non-existent economic growth, lousy demographics and political problems? There appear to be three parts to the answer.

First, German equities almost certainly over-reacted to all the gloom: even if all those German horror stories are right, the value of quoted German stocks, or at least some of them, more than fully reflected all the bad news.

Second, some of those political woes for the government have been caused by the introduction of real structural economic reform. It may look glacial to outsiders, but the pace of reform, from a German perspective, has accelerated.

Third, one or two companies have decided that it is "restructure or die", whatever the government is doing.

Recognising all of this, some investors have bought German stocks.

Other European equities have also done well. France, for example, has had a much better economy than has Germany and stocks have performed accordingly. Interestingly, French and German stocks have been joined at the hip for the past two years, despite very different macroeconomic news.

The upshot of all of this is that it appears that the European equity market is simply becoming an extension of Wall Street. European companies have learned to adapt to lower domestic economic growth. Many European firms are as profitable as their US competitors. Investors who focus on Europe's economic woes ignore this important fact at their peril.

If European equities are to be seen in this light, then the only differentiator between them and the US will be the exchange rate. The only chance for European stocks to outperform will come from any rise in the euro (or, less likely perhaps, a sudden surge in domestic growth).

The reasons why few commentators can get excited about Europe's growth prospects are well-rehearsed; while the US offers a better environment, its equity market seems to have priced in most of the good news. Investors in both regions should expect positive but relatively unexciting returns.

As always, perhaps, the excitement will come from Asia and other emerging markets. That is where both the growth and the risks will be. If it is trendy to be obsessed with China, it is still right to bet that the growth story will continue. But the focus on China does mean that other countries and regions can get neglected.

In this regard it is worth mentioning the recent performance of many Latin-American markets. Investors in this region always get a roller-coaster ride but have been enjoying some healthy returns over the past couple of years. Quietly, Latin America seems to be doing well - never a region for the faint-hearted, it might nevertheless offer returns as good as some of the more familiar Asian markets do.