Kathleen Dewandeleer: Eurozone can still deliver good returns

THIS is without doubt one of the most testing times the eurozone has faced since its inception in 1999.

Fears of a sovereign debt default are rife. Concerns of contagion from periphery countries to the wider region are intensifying. EU member states have acted: first, bailing out heavily indebted Greece, and then by launching a ?750 billion loans package to defend the embattled euro. But markets remain jittery; risk appetite has evaporated, with investors dumping equities. Some analysts are even starting to question the viability of the single currency project. Is it time, then, to abandon European equities?

We think not. The sovereign debt issue is certainly a concern, but away from this there are a number of reasons to be reasonably optimistic. Economic fundamentals remain strong, with the global recovery firmly on track. The corporate environment is also improving, with companies once again delivering encouraging earnings numbers. China's recent announcement that it has no plans to offload European debt has also gone some way to soothe traders' nerves.

This, though, is not to diminish the challenges the eurozone faces. Investors will certainly need to be more mindful of individual nations' economic and fiscal problems when choosing what companies to buy. Those in core European markets will increasingly find their shares in demand. Good stock selection, however, will be key.

Greece's travails are well-known: years of profligacy have left the nation's finances in a mess. In May, its government finally went cap-in-hand to its eurozone partners and the IMF for emergency funding. In return for the ?110 billion loan, Greece must pass painful and far-reaching reforms. So far politicians have shown willingness to make the necessary cuts. But the country has been fudging its finances for years and more will be needed before confidence is restored. The Greek populace, never one to shy away from incendiary public protest, could yet stymie the government's plans.

There are also dangers lurking elsewhere in the euro area. Italy, Ireland, Portugal and Spain are all struggling under their own huge debt burdens. The latter's banking sector is teetering. Number crunchers in those countries are busy performing their own mathematical permutations. The balance between appeasing the market without stifling economic growth is monumentally tricky.

But no matter how unpopular subsequent fiscal measures are, governments will have to enact them to tackle their deficits. Their own long-term funding depends on it. Already we are seeing evidence that politicians are getting serious, with Spain and Italy announcing severe austerity packages.

On top of these cuts, however, structural changes are needed. The peripheral eurozone countries have become markedly less competitive since joining the single currency. This will need to be addressed if long-lasting growth is take hold. German's notoriously thrifty consumers must also be encouraged to loosen their purse strings for the good of the rest of Europe.

Of greater importance, perhaps, is that the debt crisis has exposed failings at the heart of the eurozone project. First, it has shown that while the EU may be a single entity, it contains economies with a high variance of risks. Second, the crisis has undermined global investors' confidence in the euro; the single currency has fallen 17 per cent against the dollar since November. Third, it has highlighted the lack of policy structures in place to deal with country-specific problems. Lastly, we have also seen the resurgence of beggar-thy-neighbour policies, typified by Germany's recent unilateral ban on "naked" short selling of eurozone sovereign debt; a move that angered the market and Berlin's European neighbours. This, though, was more to do with domestic politics than a deep-seated attempt to reform financial markets. Faced with the electorate's ire towards Greece's extravagances, Angela Merkel, the German chancellor, must be seen to be acting tough – and speculators are always an easy target.

So, with sovereign debt casting such a long shadow, why do we remain reasonably optimistic about European equities? For one thing, the economy's revival is progressing well. The EC economic sentiment measure points to a return to growth at near-trend pace. Meanwhile, industrial production advanced by a substantial 3.8 per cent on the quarter for the first three months of 2010. Elsewhere, April's PMI survey reached its highest level since October 2007.

The business climate is also improving, and we are witnessing the return of inventory rebuilding by companies. Firms are once again being rewarded for meeting or beating earnings forecasts. Many have rebuilt their balance sheets and have strong cash flows. We are also seeing a genuine pick-up in demand. Further, according to Morgan Stanley, European companies make around 40 per cent of their earnings abroad. A falling euro will heighten these returns.

None the less, this is a challenging period for the eurozone. The sovereign debt crisis will not go a way overnight. A number of difficult decisions await the leaders of its member nations. Whether they have the fortitude to make them will soon become apparent. Expect a period of uncertainty in the market until they do. Equities, however, still represent good value and through shrewd stock picking an investor can look forward to solid returns over 2010.

Kathleen Dewandeleer is Investment Director, European Equities, at SWIP