Buyouts give Europe a boost

"For equity investors, Europe has been the place to be in 2006," says Tony Dolphin of Henderson Global Investors. "During the first three-quarters of the year, European equity markets, as measured by the Morgan Stanley Index, rose by 17% in US dollar terms." That's behind the emerging markets, but well ahead of North America and Japan. "And this is not just a flash in the pan." Over the last three years, the region has returned 77%, much more than other developed market regions, despite the lower growth rates of the eurozone countries.

So why have European markets done so well? One reason is that companies have become good at cutting costs, allowing them to "translate modest economic growth into strong profit growth", says Dolphin. And the "de-equitisation" phenomenon has also helped significantly, says John Authers in the FT. The low cost of debt financing has led to a boom in buyouts and share buybacks. The result: a lot of companies have left the market and the valuations of those that remain have risen.

But can Europe continue to do so well? The outlook is mixed. There are concerns, says Kevin Gardiner of HSBC. The European Central Bank is in a hawkish mood and rising interest rates aren't good for equities. "Eurozone earnings may also face downward pressure from a strong euro."

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And investors should also bear in mind cyclical effects. "Continental Europe is a more cyclical market than the US"; it has gained on strong global growth in recent years, but is likely to lag as we head into a slowdown.

That said, valuations in Europe still look attractive, says Gregor Logan of New Star Asset Management in Investment Week. "The major European indices trade on price/earnings ratios below their US and Japanese peers" (an average of just under 14 times). Meanwhile, "economic data in continental Europe has been upbeat, although there is some concern that the upcoming rise in German VAT could act as a brake on growth".

Even if the medium-term outlook is murky, the next few months should turn out to be good ones for investors. Despite the recent interest-rate rises, debt is still cheaper than equity and this should result in further de-equitisation, says Authers. "There may be cause for concern on the fundamentals, but financial engineering should yet eke out some more gains in Europe."