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Quarter-End Insights

September Rise Fuels European Markets' Gains

European stock markets improved on their second-quarter performance in the third quarter, but the region is still delicately balanced.

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European stock markets improved in the third quarter over their performance in the preceding period, but that was made possible only as late as September, after the U.S. Fed spurred somewhat of a global rally, albeit a short one, when it said it would stick to its bond-buying plan, quelling fears about a tapering of the program.

But for the most part, the region's bourses turned in another indifferent performance, falling back into the same stop-start pattern seen during the height of the Greek debt crisis about a year earlier.

July was not uneventful for Europe despite the absence of major market-moving news. Stocks initially rose as eurozone finance ministers in late June agreed to give the region's permanent bailout fund the authority to directly capitalize banks but said national governments will need to assume responsibility to ensure the minimum capital buffer.

Apart from this, news during the month was mostly negative. First-quarter GDP data showed a 0.2% sequential contraction, in line with estimates, completing a dismal six consecutive quarters of declining economic growth. The unemployment rate in the eurozone increased to 12.2% in May--revised up from the 12.1% reported earlier. And Greece became the first developed country to be cut to emerging-market status by MSCI following a drop of 83% for the country's stock markets since 2007.

Concerns also arose over Portugal after the resignation of two senior ministers raised misgivings about the country's commitment to adhere to austerity measures. Rising political tensions in Egypt added to investor nervousness, and the markets lost some of their earlier gains. They fell more after the ratings firms also weighed in with downgrades. S&P cut its sovereign rating of Italy by a notch to BBB, and Fitch downgraded France from AAA to AA plus. Meanwhile, the IMF lowered its 2013 global growth forecast to 3.1% from 3.3%.

Still, MSCI's standard country index showed a 6.5% gain for the U.K., while Germany and France rose 6.5% and 9% each in July.

Banking stocks received a boost during the month after the ECB said it would change some of its lending rules to make it easier for commercial banks to access ECB credit. BNP Paribas (BNP) gained 14% during the month and almost 20% over the quarter, while Societe Generale (GLE) gained about 15.5% in July, and almost 40% for the quarter. Crédit Agricole (ACA) gained 8.5% and about 24% overall.

Over in Frankfurt, Deutsche Bank (DB) added about 7% in July but ended up just about 5% higher in the three-month period.

In contrast, U.K. banks ended mixed. HSBC Holdings (HSBA) ended the quarter flat while Barclays (BARC) fell 7%. Lloyds Banking Group (LLOY) gained about 20% while RBS (RBS) was up 32%.

But the markets fell in August. MSCI's standard index for Germany and France fell 2.6% and 2.2%, respectively, while the U.K. declined 1.2%. Investors feared the U.S. Fed would announce the beginning of the end of its quantitative easing program, depressing markets. Reports that Greece would require another bailout and political developments in Italy also affected markets.

The ECB left its interest rates unchanged for the third consecutive month after some improved economic data. The Bank of England also kept its record-low interest rate and stuck to its own quantitative easing program, as data gave it room for maneuvering policy.

But importantly, amid the batch of mostly positive data, the region returned to positive economic growth after a lengthy recessionary period, as GDP for the second quarter stood at 0.3%, driven by stable business conditions in Germany and France. However, unemployment remained high.

Car sales dropped to their lowest ever in August since the European Automobile Manufacturer's Association began keeping records in 1990. Most car stocks are marginally down since the data was released on Sept. 17, but investors in the sector have mostly been rewarded handsomely during the quarter as a whole.

While France's Peugeot (UG) saw the biggest decline in sales of 18%, its stock is nevertheless up a whopping 100% over a three-month period through Sept. 27. Similarly, although shares of Europe's biggest carmaker Volkswagen (VOW) have declined about 4% since the data was released, they are up about 14% in the quarter.

The figures showed that luxury carmakers such as BMW BMW performed better than mid-market brands like Peugeot and Volkswagen. BMW shares are up about 19% in the quarter.

In September, the markets rose, spurred by the U.S. Fed after Chairman Ben Bernanke unexpectedly said recent economic data had not provided enough reason to wind down stimulus measures. However, the Fed still has two more meetings before the end of the year, and it hasn't closed the door on tapering.

MSCI's standard index for Germany gained 9.1% during the month and 13.1% for the quarter. France was up 8.7% and 15.9% overall, while the U.K. rose 5.9% in September and 11.5% overall.

Sector-wise, financials and IT gained 16.8% and 18%, respectively, for the quarter. Industrials were also up about 18%, while telecommunication services rose 21%.

Consumer discretionary stocks outpaced consumer staples, rising 18.3%, while staples rose just 7.2%. The auto sector was up 22.5%, while auto components registered a 24% increase. Specialty retail stocks were among the better performers, up 28%. Metals and mining stocks gained almost 25%.

During the month, in Germany, Chancellor Angela Merkel swept to victory in the federal elections for a historic third term. But the markets ended lower on the day with Merkel still needing to find a coalition partner. However, investors have responded well to the developments since, comforted by a likely continuation of policy toward what an increasing number of Germans see as fiscally careless fringe European countries.

Economic indicators continued to remain encouraging, with research group Markit's composite PMI showing an expansion in factory activity and an uptick in business activity in the eurozone.

Also, encouragingly, at the end of the quarter, the London-based Center for Economic Policy Research and the Bank of Italy said that, according to their jointly compiled Eurocoin measure, the eurozone economy grew in September. The measure, which has been broadly accurate all along, indicated an expansion of 0.12% in September from minus 0.04% in August. However, official figures for third-quarter economic growth will be released after Nov. 14.

However, a number of threats to the eurozone remain, not least of all, the Greek debt crisis and Germany's stance on the issue, as well as the crumbly inconsistencies of Italian politics.

Rouhan Sharma does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.