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Should European markets be back on the menu?
It has been and remains a tough time to be a European equity fund manager. That generally should be considered an immediate warning to look out for lame excuses as to why a fund is underperforming.
Or it might actually be an interesting way of thinking about how political uncertainty, combined with an arguably overvalued bond market, is having repercussions for equities.
But firstly, in a global context, Europe remains off the ‘menu du jour’ – and has been absent for well over a year now.
That may not change in the short term, as the output from the UK kitchen – the post-Brexit vote – looks decidedly unappetising.
There are also concerns that politics will remain a distraction for at least the next 12 months, starting with the Italian referendum (on a very logical reform to the electoral system) in December, the French elections in May 2017 and the German elections in the autumn of 2017.
If your objective is to find reasons for taking a ‘half empty’ view of the European glass, it is pretty easy.
A typical European squabble
That is exactly what has been happening all year to European equities. Once the noise of the US election has faded, the focus may once more switch back to European politics.
We will know in a year’s time whether the Brexit vote in the UK was just an isolated protest vote (albeit a very unfortunate one in my view).
But in the meantime, Spain has finally found a compromise following elections earlier this year, and we expect to see a new government in place any day.
A small region of Belgium almost scuppered a long-negotiated deal between Canada and the EU, but at the last minute that too was settled, albeit following a clumsy eleventh-hour wrangle all too typical of our European leaders.
Back in the ‘real’ world of economies and companies, the data coming out of Europe (not including the UK) is looking better.
The optimism in early 2015 was that European growth would recover to around 1% to 1.5%, and that is now looking realistic.
That confidence is in marked contrast to the situation a year ago. The European Central Bank (ECB) – as well as a range of economists – has been able to fly kites, suggesting that tapering of the region’s huge quantitative easing (QE) stimulus programme may soon be on the agenda.
That has led to a long overdue sharp sell-off of bonds, taking German 10-year yields from -0.1% to a rather more positive 0.1%. That may sound insignificant, but the effect on those longer-dated growth stocks trading at relatively high valuations has been quite harsh.
Localised seams of earnings recovery
While Europe’s economies have recovered somewhat in 2016,
we expected a similar revival in profits, potentially 12% on average.
For the third year in a row, however, that 12% has eroded away to zero.
The expectation for 2017 – also currently 12% – will almost certainly be too optimistic, as the numbers are predicated on seeing a positive bounce in mining, materials, banks and energy.
There is a rich seam of ‘5% to 10%’ potential growth across multiple sectors and individual stocks in 2016 and 2017.
And it is here that the problems have arisen, because that ‘rich seam’ has been extensively exploited over the last three years. That leaves a range of stocks trading at a large premium* to both the market and their own history.
If one of these misses a single heartbeat, the reaction has been harsh: Novo Nordisk has de-rated and Ericsson has plummeted, for example.
Since most companies invest for the longer term, there will always be slower periods, especially with uncertainties like a rancorous US election campaign and Brexit.
The market may choose to use those periods to reset expectations, with an associated sell off. That, together with a tiny change in interest rate expectations (does anyone hear the flap of a butterfly wing?), has accentuated this year’s rotational trends within markets even more harshly.
Vacancy at the top?
So where does that leave us? We now have a very diverse market with no clear trend of leadership. That may well change over the next 12 months.
There is every reason why the general loathing of European assets has gone too far, on the basis that many European companies are genuine world leaders, and Europe’s economies are generally accepted as being in a stronger position than they were a few years ago.
Political extremes will receive far more press than in previous election years, but perhaps the uncertainties now obvious in the UK may show it is easier to talk about a radical change to policy than actually achieve it.
Finally, in a low-growth world, paying a premium for a reliable European growth name might actually make sense, particularly given that the recent fall-out in markets has removed most – if not all – of that premium.
Having a judicious mix of quality growth stocks, along with some attractively valued cyclical recovery names, might just start to work again.
About the fund manager and Henderson EuroTrust
Tim Stevenson is Director of European Equities at Henderson and has over 30 years’ investment experience. His career in the investment industry began in 1983 as a European Analyst at Savory Milln. In 1984 he joined Aetna Montagu Asset Management where he was responsible for European Investments for pension fund clients. He joined Henderson in 1986 as a Fund Manager for Europe, with responsibility for overseas clients. He graduated from Sussex University with a BA (Hons) in Economics and European Studies.
Henderson EuroTrust invests predominantly in a mix of large and medium-sized companies based in Europe but excluding those in the UK. Tim Stevenson’s style is to orientate himself towards companies he believes are good quality and that have strong long-term growth potential but aren’t too expensive.
Investors judge ‘quality’ on a host of factors: the financial strength of the business, how much cash it generates, how entrenched its market position is relative to its competitors or the long-term viability of the business model. Fund managers will also apply more subjective views such as the ability of management to deliver on their strategy.
‘Growth’ investing seeks stocks whose earnings are expected to grow at an above average rate relative to the industry or market. This typically translates into faster growth of capital but lower levels of income in comparison to ‘income’ investing, which seeks out high dividend paying stocks.
Growth investing also tends to be riskier, and higher valuations may be placed on ‘growth’ stocks in comparison to ‘income’ stocks, however Stevenson is cognisant of not wanting to overpay for stocks regardless of the implied future growth of earnings. In addition, Henderson EuroTrust’s board is aware of the income it pays its investors, and has been growing its dividend since 2005.
Stevenson believes growth comes from a number of sources, for example when a business restructures, streamlines its operations and outsources more, applies a new technology to its processes, or catches the tailwind of changing demographics.
He is supported by his colleagues on the European desk at Henderson where research is conducted in-house, and will regularly meet with the management of companies in which he invests to evaluate their progress.
Before investing in an investment trust referred to in this article, you should satisfy yourself as to its suitability and the risks involved, you may wish to consult a financial adviser.
The value of an investment and the income from it can fall as well as rise and you may not get back the amount originally invested.
Nothing in this article is intended to or should be construed as advice. This article is not a recommendation to sell or purchase any investment. It does not form part of any contract for the sale or purchase of any investment.
Issued in the UK by Henderson Investment Funds Limited (reg. no. 2678531), incorporated and registered in England and Wales with registered office at 201 Bishopsgate, London EC2M 3AE, is authorised and regulated by the Financial Conduct Authority to provide investment products and services.