ECONOMY

Will ASE keep gains?

As 2005 draws to a close, most of the pundits appear to have made up their minds about the prospects of stocks and bonds in the new year. If they are right, we should expect 2006 to be another good year for the Athens Stock Exchange and a relatively poor year for government bonds. Of course, the pundits are not always right. However, one has to give them credit for making better predictions this year than in 2004. Is their 2006 forecast a good call? We think so, at least for the first half of 2006. To remind readers, market consensus erred in 2004 when Greek equities went on to produce superior returns compared to most of their European Union counterparts and government bonds advanced despite forecasts to the contrary. Of course, 2004 was a bumper year for the local market, since it gained up to the March general elections, dipped from there on up to the Olympic Games, to stage a stronger comeback in the last four months of the year.  Forecasts worked better in 2005, since it turned out to be a relatively smooth year with the exception of March when the Athens bourse felt the pinch of foreign funds cutting the equity allocation in their portfolios and flying to emerging markets in search of safer alternatives. Skyrocketing oil prices caused a lot of havoc but the resilience of both the Greek and major Western economies to the shock provided relief. So, unless something dramatic happens in the last week of the year, the Athens Stock Exchange will be a top performer among developed markets worldwide for the third consecutive year, producing returns in excess of 25 or even 30 percent, depending on the share index used as a proxy. On the other hand, government bonds will most likely end the year stagnant to lower as the US Federal Reserve continued to increase its intervention rate and the European Central Bank (ECB) finally agreed in early December to up its official rate by a quarter point to 2.25 percent.  Of course, this is history but some of the investment themes of 2005 appear to be set to play into 2006 as well, supporting the view that the new year will be another good year for Greek equities, although demanding valuations and forecasts for higher euro interest rates cast a cloud. Higher euro rates appear to be the driving force behind predictions of poor performance by EU government bonds next year. The prospect of higher euro rates is very likely with the ECB’s intervention rate seen between 2.75 and 3.25 percent by end-2006. Higher short-term rates make the funding of medium and long-term government bonds more expensive, weakening demand by banks and other funds trying to gain the spread. They also make other investors, such as retail, demand a higher compensation for buying medium-to-long-term bonds. This can come in the form of lower prices and higher yields from outstanding fixed coupon bonds. Fiscal effect In addition to higher funding costs, Greek government bonds in particular will also be affected by the outcome of efforts to bring the budget deficit to below the 3 percent of GDP limit set by the EU and reduce the public debt as a percentage of GDP. If the government succeeds in putting its public finances in order, it is very likely that international credit rating agencies will start contemplating an upgrade in the country’s long-term debt, which would materialize in late 2006 or 2007. This is something the market will rush to discount. And should counterweigh, at least partially, the adverse effect of higher euro rates on Greek bonds. In general, higher interest rates do not bode well for equities either. First, they increase borrowing costs for companies, hurting their earnings. Second, they make money money instruments and higher yielding bonds more competitive to equities, leading some funds to transfer money out of equities and into bonds or other interest rate instruments. Greek companies are not an exception to this rule. However, the level of short-term interest rates will remain low even after their anticipated increase and will hit firms most in working capital, limiting the potential damage.    Contrary to bond investors, who will be looking to progress on the fiscal front, equity investors will be preoccupied with growth. Unlike 2005, when most private forecasters estimated GDP growth to between 2.5 and 3.3 percent, which turned out to be much lower than the actual 3.5 to 3.6 percent, market consensus is more optimistic for 2006. It puts GDP growth rate at between 3.2 and 3.5 percent, easily beating the average GDP in EU-15, seen as below 2.0 percent. This is definitely a much more realistic estimate, providing a good start for the top line growth – namely sales growth – of many listed Greek companies, which should trickle down to the bottom line. Another reduction of 3.0 percentage points in the corporate tax rate to 29 percent will help magnify the positive effect on after-tax earnings, justifying demanding valuations. Most Greek heavyweight stocks, mainly banks, trade at a premium to their European peers in terms of popular valuation metrics, such as the price-earnings ratio (P/E), reflecting their higher growth potential. This has been the case for at least two years. Moreover, the bottom line of Greek banks and other firms is expected to be boosted by profits earned by their operations abroad, mainly in the other Balkan states. With ample liquidity abroad and private equity funds seeking opportunities across markets, it is likely that speculation about leverage buyouts (LBOs) and other corporate activity will pick up in 2006, engulfing companies from other than the telecommunication sector. It is noted that Texas Pacific Group and Apax Partners gained control of Q-Telecom, a division of listed Qwest, and US-listed TIM Hellas mobile company in 2005. Another private equity fund took a stake in excess of 20 percent in listed Forthnet. Already, there is speculation that private equity funds have targeted at least one listed company from another sector. In addition to LBOs, there is market talk about ongoing negotiations about potential M&A deals between small banks and Credit Agricole’s gaining control of Emporiki Bank and OTE’s absorption of its subsidiary CosmOTE.     Without discounting the risks that a sharper-than-expected increase in euro interest rates will entail, the uncertainty over the price of oil and the euro-dollar interest rate, the bulk of Greek heavyweight stocks should have another good year in 2006. If GDP growth holds well and the environment in international financial markets stays benign, we see no reason why the valuation-wise rich Greek stocks should not register further gains at least in the first half of 2006. Even more so if the government broadens its privatization agenda to lure in new and old players, such as pension funds, and also pleases large investment banks.