The European Smaller Companies Trust Fund Manager Commentary – July 2022

Macro backdrop

Equity markets moved higher despite further interest rate rises. The US Federal Reserve (Fed) increased rates by 75 basis points (bps) for the second month in a row while the European Central Bank (ECB) announced a larger-than-expected 50 bps rise.¹ Investors were encouraged by some lead indicators (notably money supply) beginning to show the first signs of a better outlook for the second half of this year. This was driven on the one hand by China adding more monetary stimulus, but also inflation rate momentum slowing down -with absolute levels of inflation perhaps peaking. Crude oil prices fell due to worries about inflation and the expected corrosive effect on demand, pushing US benchmark West Texas Intermediate (WTI) below US$100 per barrel, although signs that supply remained tight limited the overall losses.

Trust performance and activity

Fund returns were largely driven by an intense earnings season rather than any top down factors. Positive earnings surprises came from ferry operator DFDS, where fuel costs had caused expectations to be lowered ahead of results, projectors and conferencing equipment Barco, and Nexans (which produces cabling used for grid and renewables).² On the negative side was wealth manager Van Lanschott, where investors used a lowering in interest rate forecasts to sell down a share which has been relatively resilient during the broader market sell-off. HelloFresh (meal kits) announced disappointing numbers and is the latest consumer-facing stock to suffer during the current cost of living squeeze.³ Activity involved the purchase of Iveco, the truck manufacturer which was spun out of CNHI in late 2021. The company has been doing a good job of balancing price rises with cost inflation and has been taking market share. We also bought Commerzbank, a company with a troubled past where we were attracted to the self-help potential. We sold Aareal bank, Basware and Bobst which have all been subject of a bid. While a ceasing in credit markets may slow merger and acquisition (M&A) activity, we expect management teams and private equity firms with cash piles to continue to look at our investment universe.

Outlook/strategy

The current bear market -not just in equities but also bonds, cryptocurrency and now extending to commodities -had primarily been induced by inflation, or rather the central banks’ fight against inflation. The bear markets of the 1960s and 1970s played out in similar fashion, as did the 1994 correction. Equity markets back then troughed when inflation and interest rates peaked. We note that so far at least, the US 2-year sovereign bond yield peaked in mid-June. Even though it seems that Fed interest rate hikes will still be ongoing for a few meetings longer, bond yields are already anticipating the peak. The US personal consumption price index saw its peak month-over-month and year-over-year growth rates in March. Notably, in their latest meetings both the Fed and the ECB have abandoned forward guidance. Instead, both central banks have flagged that the further rate hike path from here is going to be data-dependent. That being said, geopolitical tensions remain elevated with China-Taiwan hostilities being added to the risk of a Russian gas shut down. Ultimately, we are happy to not be taking a big bet on the cycle within the portfolio, either in terms of cyclicality/defensives or via a growth/value tilt.

Glossary Expand

Basis points (BPS) – A common unit of measure for interest rates and other percentages in finance. A 0.01% change is the same as 1 basis point.

Bear market – A financial market in which the prices of securities are falling. A generally accepted definition is a fall of 20% or more in an index over at least a two-month period. The opposite of a bull market.

Cyclical stocks – Growth investing Companies that sell discretionary consumer items, such as cars, or industries highly sensitive to changes in the economy, such as miners. The prices of equities and bonds issued by cyclical companies tend to be strongly affected by ups and downs in the overall economy, when compared to non-cyclical companies.

Defensive stock – A defensive stock is a stock that provides consistent dividends and stable earnings regardless of the state of the overall stock market. There is a constant demand for their products, so defensive stocks tend to be more stable during the various phases of the business cycle.

Growth investing – Growth investors search for companies they believe have strong growth potential. Their earnings are expected to grow at an above-average rate compared to the rest of the market, and therefore there is an expectation that their share prices will increase in value.

Inflation – The rate at which the prices of goods and services are rising in an economy. The CPI and RPI are two common measures.

Monetary policy – The policies of a central bank, aimed at influencing the level of inflation and growth in an economy. It includes controlling interest rates and the supply of money. Monetary stimulus refers to a central bank increasing the supply of money and lowering borrowing costs. Monetary tightening refers to central bank activity aimed at curbing inflation and slowing down growth in the economy by raising interest rates and reducing the supply of money.

Sovereign bonds – Bonds issued by governments and can be either local-currency-denominated or denominated in a foreign currency. Sovereign debt can also refer to the total of a country’s government debt.

Valuation metrics – Metrics used to gauge a company’s performance, financial health and expectations for future earnings e.g. price to earnings (P/E) ratio and return on equity (ROE).

Volatility – The rate and extent at which the price of a portfolio, security or index, moves up and down. If the price swings up and down with large movements, it has high volatility. If the price moves more slowly and to a lesser extent, it has lower volatility. Higher volatility means the higher the risk of the investment.

Yield – The level of income on a security, typically expressed as a percentage rate. For equities, a common measure is the dividend yield, which divides recent dividend payments for each share by the share price. For a bond, this is calculated as the coupon payment divided by the current bond price.