Europe’s Joy Ride Will Be Tough Act to Follow

NEW YORK —  Europe’s equity markets, red-hot in the first quarter, turned mixed in the second quarter as high stock valuations and jitters over interest rates and Asia triggered some profit-taking.

Still, for the first half of 1998 overall, European markets have utterly dominated global performance charts--reflecting widespread optimism about coming monetary union.

While the U.S. Standard & Poor’s 500 index is up 17.3% this year, many European markets have bettered that mark, led by Greece (up 63% in the native currency) and Finland (52%) and closely followed by such larger markets as France (42%) and Germany (40%).

However, some Europe watchers think the best of the joy ride may be over. While few are predicting a sharp downturn despite recent pullbacks in some markets, even fewer believe that European stocks can come close to matching their first-half gains in the next six months.

Why? To begin, it helps to examine the factors that have helped produce the sizzling first half.

The macroeconomic picture across Europe “is as good as it has looked in 10 years,” said Jonathan H. Francis, head of global strategy for Putnam Investments, the Boston-based mutual fund giant.

Inflation is almost nil, interest rates are low, consumer demand is strong and European companies have yet to achieve the full benefits of a restructuring wave that arrived there years after it hit U.S. shores.

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The extraordinary monetary unification set for Jan. 1, when 11 nations align their interest rates and begin phasing in a single currency--the euro--has also been part of a positive backdrop for stocks.

Yet many European large-capitalization stocks began 1998 far more cheaply valued than their U.S. counterparts, said Jean-Marie Eveillard, manager of the SoGen International Fund in New York.

Take Nestle, the Swiss foods conglomerate, for example. It began the year trading at a sharp discount to comparable U.S. stocks such as Sara Lee Corp. and H.J. Heinz Co.

The same could be said of Unilever, the Anglo-Dutch detergent and food giant, which six months ago traded at a significantly lower price-to-earnings multiple than U.S. rival Procter & Gamble Co.

Value investors in the United States spotted these bargains. And European investors--traditionally far more bond-oriented than Americans--finally decided they could no longer overlook stocks.

The result was a buying spree that has powered European markets to spectacular gains.

Now look again. After a 42% surge since Jan. 1, Nestle has caught up to Sara Lee and Heinz in terms of P/E, and Unilever--up 32% this year--has nearly reached the P/E commanded by blue-chip P&G.;

“In the U.S., big stocks have done better than smaller ones,” Eveillard said, “but it’s even more so in Europe.”

In other words, he said, big-stock bargains are no longer easy to find in Europe.

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Going forward, Francis of Putnam believes that the Asian economic crisis will squeeze corporate profit margins in all developed countries as competing Asian exports grow cheaper. But the U.S., as a bigger trading partner with Asia, is more vulnerable, he said.

European stock markets therefore should continue to outperform Wall Street for the rest of the year, he predicted. But the numbers won’t be special: Francis is calling for second-half gains of 5% or less.

Carl B. Weinberg, chief economist at High Frequency Economics in Valhalla, N.Y., worries that the new European Central Bank (ECB)--which will set monetary policy for the 11 common-currency nations beginning Jan. 1--may make poor decisions that could undermine the economic and stock-market booms.

Germany and France, he noted, both reported first-quarter economic growth that was the strongest in years--annualized growth of 3.8% and 3.4%, respectively.

But both countries are “still way short of any kind of capacity constraints or labor shortages,” he said. “There is a ton of headroom for these economies to expand at any imaginable rate.”

In fact, the growth rebound is making only a small dent in the nations’ unemployment rates, which remain high at 12% in France and 10% in Germany.

That’s why central banks in both countries have held interest rates at low levels.

The trouble, however, is that rate authority will soon pass to the ECB, in which Germany and France will cast only four of 18 votes on the ruling Central Bank Council.

By Jan. 1, the short-term interest rates of all the member countries must converge. The proper course, in Weinberg’s view, would be to have the economies now with short-term rates in the 4% to 5% range--Spain, Portugal, Ireland, among others--slowly bring their rates down to the German and French levels of about 3%.

In countries such as Spain, where a two-point rate cut could cause economic overheating and inflation, the government could use fiscal policy--budget cuts--to apply the brakes, Weinberg said.

He believes, though, that there is a fair chance the ECB instead will pursue higher rates in the now low-rate countries. Some hints about the Central Bank Council’s thinking will emerge in the months ahead as it begins meeting.

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Uncertainty about the council’s direction will put a damper on stock-market enthusiasm in any case, but any bias toward higher rates could kill stocks’ rally outright, Weinberg said.

Eveillard is more optimistic but still guarded. He believes that “an equity culture” is developing among Europeans and that legislation pending in several nations to make stock buybacks more attractive will be another positive factor.

With smaller European stocks lagging behind bigger ones in valuation, a move into the smaller names would seem to be a natural move for bargain hunters. But that goes against the grain of many European investors, Eveillard warned.

“The big institutional investors are so afraid of lagging the indexes [dominated by big stocks], they’ll never buy the small companies,” he argued.

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Slower Going

After a spectacular surge in the first quarter, most European stock markets rose again in the second quarter. But the gains tended to be smaller. Year to date, the dollar strengthened against most currencies, cutting into returns for U.S. investors. Returns for the quarter and year-to-date, through Monday, in native currencies and in dollars (price only, not including dividends):

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2nd-Quarter return YTD return Market Native U.S. $ Native U.S. $ Greece/ASE +16.7% +21.3% +62.7% +51.2% Germany/DAX-30 +16.4 +17.4 +40.5 +39.6 Finland/HEX-Gen. +15.4 +16.3 +52.4 +50.9 Belgium/BEL-20 +13.7 +14.7 +40.2 +39.3 France/CAC-40 +11.5 +12.5 +41.7 +39.8 Sweden/OMX +6.0 +4.5 +29.6 +28.6 Netherlands/AEX +5.0 +5.9 +31.1 +30.1 Switzerland/MI +4.7 +2.9 +25.8 +20.7 Spain/IBEX-35 unch. +0.8 +41.2 +39.3 Italy/MIB-30 -0.7 +0.2 +36.4 +34.5 Britain/FTSE-100 -0.9 -1.9 +14.6 +16.0 Portugal/BVL-Gen. -2.1 -1.1 +44.0 +42.9 Ireland/Overall -2.5 -1.0 +27.7 +24.9 Denmark/KFX -3.0 -2.0 +12.1 +11.4 Norway/OBX Total -6.2 -7.9 +1.5 -2.5 S&P; 500 index +3.3 +17.3

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Source: Bloomberg News