Europe's jaw-dropping run

The performance of European shares this year has been "jaw-dropping", says David Bowers of Merrill Lynch. European manufacturing is heading into recession and two founder members of the European Union have rejected the new EU Constitution. Yet stocks have risen by almost 10% in 2005, and the pan-European FTSE Eurofirst 300 index and Paris and Frankfurt hit a three-year high this week.

Markets have been bolstered by the sliding euro, which boosts European exporters, while valuations have also helped: Franz Wenzel of Axa Investments notes that European stocks are about 20% below their average valuation of the past 40 years. Investors are also hoping that political upheaval could help stimulate more restructuring and reform. The prospect of political integration has now receded, leaving Europe free to focus its energies on "long overdue restructuring", says Stephen Roach of Morgan Stanley. Is this likely, and are there other reasons to expect the rally to endure?

Lehman Brothers, for one, deems European stocks a buy. The "great strides" in recent restructuring and cost-cutting among European firms have yet to be "fully appreciated" by investors, says the broker; profitability is at near-record highs. Analysts are pencilling in earnings growth of 12%-13% from Europe Inc. this year, says Vito Racinelli in Barron's. But the darkening economic outlook suggests growth will stem largely from cost cuts. And "it's not clear how much stamina Europeans have to finish the reform race". With elections looming in France, Germany and Italy over the next two years, the no' votes could now tempt politicians to opt for protectionism and anti-market populism to avoid antagonising electorates further. A rerating of European equities seems unlikely.

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Such fears look overblown, says Roach. As the world's dominant exporter, Europe has "everything to lose" by erecting trade barriers. Note too that when it comes to structural change, the key driver is private-sector restructuring, rather than government initiatives witness the impressive progress of Japanese and German firms. But investors worried about reforms may want to look to pro-market central European countries, says Conrad de Aenlle in the International Herald Tribune. Tom Elliot of JP Morgan Funds says that, with the drive towards harmonisation weakened by the referendum results, central European business leaders can rest assured that Germany and France "are unlikely to be able to foist their bad policies on them".