No brakes seen yet for rallying European stocks

European shares near five-year highs, are showing no signs of fatigue, and fund managers say a cocktail of robust earnings and takeovers will keep markets bubbling, though rising interest rates may spoil the party.

"The outlook for earnings growth is still fairly supportive, around eight to 10 per cent growth this year is not too optimistic," said Jan Leroy, a fund manager at Petercam Asset Management.

Volatility in markets might however rise later this year on concerns about a slowdown in US housing growth and higher interest rates, he said.

Interest rates look set to rise twice more in the United States and the euro zone this year, while the Bank of Japan should start to tighten towards the end of 2006, according to a Reuters poll of economists.

On Monday, the pan-European FTSEurofirst 300 index rose as high as 1,379.6 points, its strongest level since early July 2001, boosting gains to eight per cent so far this year.

As the fourth-quarter earnings season winds down, fund managers said a majority of companies were reporting results ahead of market estimates.

"Earnings support, particularly in the UK has been good. Banks have produced very solid earnings growth and then there's support from oil earnings and basic materials earnings," said Andrew Lynch, a European fund manager at Schroders.

The DJ Stoxx European financial services index is spearheading the equities rally so far this year, with a nearly 19 per cent jump, driven by hefty profit growth and M&A speculation, followed by the construction and materials sector.

Laggards include travel and leisure and telecoms shares. "We continue to see the biggest upward surprises from the financial sector. Profit growth has been quite good, the results season has been favourable and analysts continue to raise their numbers," said Merrill Lynch strategist Khuram Chaudhry.

Strategists at Lehman Brothers said that although European quarterly earnings growth had dipped, there were no indications yet that growth will fall sharply.

"There are signs that the super-strong earnings environment which has prevailed in Europe in the past two years may be starting to slow a little," Lehman strategists said in a note.

"Although there is some slowing in the earnings cycle, there are no signs yet of a drastic decline in earnings growth or extreme margin pressure which should worry investors.

"Earnings growth is approximately at the same level as Q3 and remains at a healthy 23 percent on an annualised rate. On a quarter-on-quarter basis, however, there has been a drop of about 3 percent in the earnings growth rate," the note said.

Commodity costs are rising but European companies have managed to offset these in the last few years by cutting costs and restructuring businesses, while also benefiting from strong growth in export markets.