PS: Last year saw heady rises in European stock markets. Can this continue in 1998?
FLD: We expect overall gains of 15 per cent this year. We are optimistic about Italy and Spain where we look for 25 per cent gains and we like Germany and the Netherlands.
GM: We think markets will be marginally up but Asia and other concerns will prevent a repeat of 1997. The UK is our favourite on valuation grounds and Italy and Spain on convergence grounds. Germany we are most worried about.
JC: We are bullish but we don't expect such a splendid ride as in 1997. We like Italy and Spain because they will qualify for the euro and their interest rates have to fall. We dislike Germany and the Netherlands as we expect the deutschmark to rise against the dollar, hitting exports.
PS: The wild card is the impact of the Asian financial crisis on European companies. Which industries will be most affected?
GM: So far, the recovery in Europe has been driven by export growth. If competition intensifies, some earnings estimates in machinery and capital goods will not be met. Any assessment of Asia's impact on European equities has also to take what happens on Wall Street into account.
FLD: Europe will grow slowly overall with companies having no power to raise prices. Paradoxically, Asian competition should be the catalyst for European industry to consolidate further. This isn't good for jobs but it is for shareholders and will help support share prices.
PS: So far the Asian crisis has been good for Western markets as bond yields have fallen to a record low in the US. Deflation is talked about but unemployment is still falling in the US. Have we really eliminated the likelihood of a rate rise in US?
GM: A US rate rise is much less likely as the Asian disaster has changed the mix in US growth. Export growth will fall, affecting profits in some sectors, but inflation will fall and rates won't have to rise so the economy as a whole benefits. Bond yields will be lower than they would otherwise have been: some investors are worried that the risk is not overheating but recession. Lower bond yields will support equities. The moment when things get too toppy has been delayed.
JC: The problem with that is that you cannot on the one hand say growth is slowing and deflation is in the system, and on the other that profits won't suffer. I think there is the risk of a nasty squeeze if US wage inflation remains robust but companies' margins are squeezed. This is also a risk in Europe, but to a lesser extent.
The nightmare scenario for Western markets would be the Japanese situation where you have very low interest rates and no fear of inflation but companies have lost profitability. Bonds and equities part company as yields could fall absurdly low but equities are in a bear market.
PS: What impact will Asia have on European companies' earnings?
FLD: Some sectors are negatively affected, such as paper, chemicals and engineering, where companies will suffer from price competition. Luxury goods manufacturers will be hurt as consumption in Asia falls. But these sectors do not dominate European stock markets and other more important sectors such as insurance and healthcare are relatively immune. Analysts have not begun to downgrade estimates to reflect the problems so there is room for bad surprises.
PS: How much scope is there for corporate restructuring to drive up share prices?
GM: Restructuring has been a wonderful driver of share prices but investors anticipate future dividend streams very early on and a lot of the share gains last year reflected that. But it is not a fait accompli that restructuring will completely wipe out the risk of earnings downgrading as a result of Asia. The Asian fallout seems to be following a logical course. Companies with high earnings exposure in the Far East have fallen first, then mining stocks dropped, then engineering, then oil. Next is banking stocks, and some investors are not cautious enough about the impact on banks.
FLD: We assume the Asian crisis will be solved to a large extent in the next few months by a big enough bail- out to re-establish confidence in the region. The benefits of the restructuring process will outweigh the initial impact of the crisis.
PS: The UK is well down the road on restructuring. Which other countries will benefit most?
JC: Germany is where we have had a lot of talk and little action, such as the long saga of Krupp/Thyssen where after a year we still know nothing about what is happening. I will be convinced about German restructuring only when I see it.
GM: The Swiss have been the masters of restructuring in the last few years. The UBS bank merger shows the levels they are ready to go to to boost profitability. Italy and its financial services industry offer some very interesting situations and there could be good returns in France.
FLD: German companies have delivered more than they have been given credit for in enormous productivity gains, divestment of assets abroad and cost cutting. We have not seen the same effort in France, where old-style takeovers launched in the last few months have actually failed.
JC: EMU means that big companies will find Europe is a single country and will face much more price competition as a result. This will force the restructuring to continue. The whole of industry will be different in five years' time. Banks are in the headlines but the big food producers, capital goods industries and pharmaceuticals will also change. It is difficult to imagine a sector that won't be affected.
PS: Is the rise in the US dollar which has given such a major boost to European exports last year's story?
GM: The correlation of returns on German equities with the dollar/ deutschmark rate is very high. The dollar has returned to fair value in last 18 months but now it is being pushed up by the flight to quality and as Asian companies struggle to cover debt. We cannot pencil in a sharp increase from here.
JC: I am worried about the strong dollar. I see Dm1.60 by the end of the year, which will hit some markets worse than others.
FLD: We forecast a Dm1.85 rate. There is still a very strong incentive for every investor to hold US- denominated assets and this will support the dollar.
PS: What are your favourite stocks?
FLD: We like pharmaceuticals such as Astra and Novartis and utilities such as Iberdrola in Spain.
GM: We will concentrate on restructuring stocks such as INA in Italy and Mannesmann in Germany.
JC: We like to be defensive, so Telefonica in Spain, and we like restructuring stocks such as UBS. On the industrial side, Peugeot in France.
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