European shares rose on Friday but still recorded their biggest annual drop since the onset of the financial crisis as debt tensions in the euro zone strained the financial sector and threatened to derail a fragile economic recovery.
The FTSEurofirst 300 index of top European shares ended the day 0.8 per cent higher at 1000.39 in volume at less than a quarter of the 90-day average as the UK and German markets closed early ahead of the New Year weekend. Cyclicals gained, led by construction stocks and insurers, as the market extended a year-end rally on the back of a steady flow of upbeat data from the United States recently.
For the year the index fell 10.7, the most since 2008, with cyclical stocks among the worst hit as government austerity measures and a lending squeeze in the euro zone curbed economic growth.
A macro-driven trading environment saw the basic resources sector, which depends on industrial activity, fall 30 per cent in 12 months and automotive stocks -- the main driver for which is consumer spending -- drop 24.1 per cent.
"It's a very one-dimensional market. It's hard to remember a time when it hasn't been driven by just a simple risk-on or risk-off trade," Andrew King, chief investment officer for European equities at BNP Paribas Investment Partners, said.
Euro zone banks, which have the greatest exposure to the area's troubled debt, were the worst performers, losing 37.6 per cent of their value in 12 months. While writedowns on Greek debt hit the profits of banks across the euro zone, tighter capital rules forced several lenders to de-leverage, causing liquidity in the funding markets to dry up. Banks in Italy, Europe's largest debtor, and France, which risks losing its coveted triple-A rating, bore the brunt of investor diffidence, with UniCredit and Societe Generale falling 58 per cent and 57 per cent, respectively.
Tensions in the euro zone were set to continue into the new year, when Italy faces 100 billion euros ($128 billion) of bond redemptions and coupon payments by the end of April and the Spanish government is set to introduce new savings measures to tackle a higher-than-expected deficit. Some fund managers argued the current, depressed market valuations could already more than discount an economic slowdown.
The Dow Jones Stoxx 600 implies a yearly compound contraction of nearly 5 per cent in earnings per share over the next five years, according to Thomson Reuters Starmine data. "I think there's every possibility that the global economy continues to grow around trend but that isn't priced in European equities," said James Buckley, who helps manage 1 billion pounds ($1.5 billion) at Baring Asset Management.
Buckley has increased its exposure to oil services stocks, where it believes an engineering consultancy such as Fugro is positioned to benefit from a worldwide uptrend, driven by the United States and China.
The fund manager is cautious on consumer staples, which have already benefited from their defensive profile and exposure to consumption growth in emerging markets. The European Food & Beverage Sector ended the year up 5.4 per cent, led by consumer products groups such as Unilever, up 10.2 per cent on the year. The ultra-defensive healthcare sector ended the year up 11.8 per cent, with German dialysis specialist Fresenius Medicare gaining 21.4 per cent.
"I very much get the impression that the market is very crowded in the defensive, low risk part," BNP-Paribas IP's King added. "You do get into this sort of spiral where the market doesn't seem to differentiate that much."King, who adopts a bottom-up approach, has been looking for value among out-of-favour stocks that are set to benefit from market consolidation, such as Spanish banking giant Banco Santander and BBVA, which fell 26 per cent and 11.6 per cent in 2011, respectively.