Professional Investor: Global strength pushes Germany to brink of reform

The lack of a decisive election win is potentially damaging for a country's equity market, but Germany's DAX index seems largely to have shrugged it off. This reflects a strong sense of optimism that the country's faltering economic growth and post-war record unemployment levels have created a consensus that the economy must change.

Before the election, the CDU advocated a series of market-friendly changes, including cuts in income and labour taxes, relaxation of the country's stifling employment regulations and an increase in VAT.

However, the CDU must now agree a common policy with its coalition partner, the Social Democrats - a process that is likely to take some time.

On a positive note, both parties promised to reduce corporation tax. Companies (and, therefore, shareholders) that would benefit from this include those that rely on domestic income, such as Deutsche Post. Other beneficiaries of CDU policies might include the defence industry - as the party favours a more lenient approach to exports - and utility groups, if the party succeeds in extending the life of nuclear power stations.

But changes to government policies will only begin to reinvigorate the economy if coupled with on-going corporate reform and restructuring. The past 18 months have seen a number of positive moves by some of the biggest names in German industry, including Siemens, which recently announced an ambitious cost-cutting programme.

European corporate giants are finally being forced to change as they face increasing competition from both China and Eastern Europe.

The fast-growing economies of Eastern Europe are benefiting from widespread investment and modernisation programmes, and offer cheap and highly skilled labour forces. Investors in European equities can capitalise on this trend by looking for companies that have tapped into this potential

In the banking industry, Western European groups, such as Erste Bank and Bank Austria, are benefiting from their operations in these markets, which boast high organic growth rates. Austrian oil and gas group OMV is reaping the rewards of an acquisition in Romania.

Private equity investment is another catalyst driving a shake-up in corporate attitudes and structures across Europe. As an increasing number of the region's private companies are restructured under this type of ownership, public companies are also compelled to re-think, often becoming more shareholder focused. Although investment levels remain well below those in the US, Europe's cash-rich venture capital sector is also stoking merger and acquisition activity. This is encouraging consolidation in a number of relatively fragmented industries.

The banking industry is one area where we are seeing more activity, with smaller German, Spanish and Italian groups leading the way. During the past year, investors in German group HypoVereinsbank have seen its share price rise considerably following Italian bank UniCredito's takeover bid. Many hope that this transaction will clear the way for more deals.

Focusing on companies with strong cash flows has also worked well for investors recently. Continental stock markets began to rally in early summer and have continued to climb, undeterred by gloomy economic data and the political crisis faced by the European Union following the rejection of its proposed constitution.

This resilience highlights the market's underlying strengths. Despite recent gains, the valuations of European stocks are low, relative to bonds and US equities. In this sense, Europe's economic doldrums have created opportunities for investors, as markets have priced an overly negative macro-economic view of the region into many stocks.

Despite the region's 0.5 per cent growth in gross domestic product, Europe's corporates are thriving. The strength of the global economy is driving profit growth across the region, and with Germany on the brink of economic reform, the outlook is optimistic.

Roger Guy is manager of the Gartmore European Selected Opportunities Fund.

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