Markets to focus on valuations (page 2 of 2)

Europe

While the 50bp interest rate cut by the FED was widely expected the European Central Bank (ECB and the Bank of England (BoE) managed to surprise markets by a decisive 50bp rate cut. The initial market reaction was positive but the euphoria faded out quickly on Friday. While lower interest rates are supportive for equity valuations we believe that at this point in time the main focus of investors should be on what could trigger earnings to recover. While equity markets tend to price a recovery well in advance investors need to be aware that the recent rally is built on very weak grounds. Economic news are getting worse and earnings expectations for next year remain at unrealistically high levels, i.e. valuations will be even more at risk when these forecasts are reduced unless stock prices do fall or interest rates head lower. We think that the ECB's statement does not give any hint that European economies and earnings could recover soon. In fact, the ECB press conference following the interest rate cut showed a central bank that has become more bearish on the economic growth outlook but at the same time more positive on the inflation outlook. This will cause further interest rate cuts by the ECB. However, as Mr. Duisenberg said that interest rates had now reached a level that is fully appropriate with the medium-term inflation outlook, it seems unlikely that another rate cut will happen in December. We expect interest rates to be cut by another 50bp in1Q02. Going forward, the ECB will only decide once a month on interest rates instead of the current bi-weekly mode. This is positive news, as it will increase the central bank's predictability.

Taking the fading interest rate element and the lack of earnings recovery into account, liquidity remains the driving force of this market. It is the reason why we do not see markets falling off the cliff but rather consolidate in a 5%-10% range. With bonds getting less attractive and cash yielding close to nothing investors will use any setback to increase the equity allocation. Should markets consolidate in the weeks ahead we would take a more aggressive stance in terms of our sector approach and reduce defensives in favour of technology and cyclicals with a clear focus on quality. However, this should be done with a 12-24 months investment horizon.

Aventis (AVE FP; EUR 80.80) reported a very good set of figures with core sales up 41% yoy at EUR 457 million versus expectations of EUR 429 million. The company's top three drugs along with the merger synergies from Rhone Poulenc and Hoechst once again boosted demand. Improved product mix and increased geographic concentration helped drive the gross margin up by 2.4% to 71.1%. Aventis is by far the fastest growing pharma company with good visibility and attractive valuation. We view the stock's pullback in response to the earnings report as profit-taking and would use the current weakness to buy the stock. Aventis is a safe place in a world of uncertain economic development, growing at a double-digit rate over the next few years. The stock lost 3.12% for the week.

Oil stocks were under pressure ahead of this week's OPEC meeting on November 14 and the release of the IEA report on global inventories on Monday. The price for US Crude West Texas Intermediate fell below USD 20 before recovering to USD 22.22. We believe that OPEC will reiterate its USD 18-22 price range for this winter and lower production levels. Even though the current oil price does not give much room for upside earnings, we believe that the strict capital discipline of the major oil companies does provide a high degree of earnings visibility. We continue to prefer TotalFina (FP FP; EUR 155.10) because of its attractive valuation and highest growth among the big majors.

Vodafone (VOD LN; GBP 1.7675) is expected to report earnings on Tuesday. According to a newspaper report Vodafone could announce a write-down of up to GBP 6bln on some of the acquisitions made during the telecom boom. It is not expected though that Vodafone will write-down parts of the GBP 13bln investments in 3G licenses. CSFB estimate Vodafone's 1HFY02 mobile EBITDA (valuation metric for Vodafone) to be GBP 4.6bln. We see a reasonable chance that this estimate could be exceeded as the company reported stabilising ARPU (Average return per user) in the UK, Italy and Germany and good results from Verizon Wireless. In general European mobile operators reported an increasing trend in margins. Vodafone remains our top-pick among the telecom stocks. However at the current price level valuations look ambitious and we want to await tomorrow's report to see whether earnings upgrades are in the cards.