Matthew Bullock (MB): Hello and welcome to the latest recording in the Global Perspective podcast series. My name is Matthew Bullock. I’m the head of Portfolio Construction and Strategy (PCS) for EMEA and APAC here at Janus Henderson. And today I am joined by Robert Schramm-Fuchs who is a Portfolio Manager for European Equities. Robert, good to have you here.

Robert Schramm-Fuchs (RSF): Cheers.

MB: So, Robert, Europe is a fascinating market right now. And it sort of feels like a mix of risks and opportunities. You know, if I’m thinking about European markets I’m thinking right now about France, I’m thinking about war in Ukraine, I’m thinking about stimulus in Germany. So, there’s a lot going on.

It’s very dynamic. And I think you’ve described Europe as being about a bit of a crossroads. So, what do you mean by that?

RSF: It is actually a bit more fundamental. We think the economic model of Europe as such is broken. It used to be a neo-mercantilist model, using regulation, laws, bureaucracy, to shield itself from imports, and exporting all sorts of goods, cars, machinery, luxury goods, to the rest of the world.

And why is that model broken? It’s because the Chinese, that’s a challenge that’s been going on for several decades, have built in many of these sectors significant capacity, cheaper production capacity. And the US has now said, well, look, no longer, you need to accept that we’ll put a tariff on you, but you can’t put a tariff on us, and you can no longer stop the influx of American products with regulation to Europe, as in autos, for instance.

And so, the basic model is broken, and the external challenges we also have. As you mentioned, the Ukraine war, the various geopolitical shifts as such, with Europe right at its heart. So th,e basic models, the basic assumptions of the last century are no longer valid for Europe. Europe needs to reinvent itself. And it’s doing this right now, and this farce represents the investment opportunity.

MB: So essentially Europe is starting to work more together. Is that is that the way you said looking at it?

RSF: Yes. Hopefully the proof will be in the pudding.

MB: I’m trying to get you to say something.

RSF: The main thing that’s going on is the reforms at the EU level, and this is something that we haven’t had before. So, it’s really the realisation in Brussels that the game is up otherwise. That is this pressure is not just the external forces that we just described. It’s the internal forces too. When you look at the mainstream political parties in Europe, in many countries, most countries, they’re back against the wall. The polling suggests they won’t make it to the next government. And so, it’s the last chance saloon to get some changes, to get the economy growing again, to create more satisfaction. And this is the only way for them to stay in power.

MB: Carry on.

RSF: And so this pressure, the external and internal pressure are culminating in Brussels and triggering that change. And yet last year the Mario Draghi report, which outlined a lot of areas where these changes should take place, or the structural reform should take place, and bit by bit, the European Commission is addressing one after the other. And with the support of the largest member states in the driver’s seat for those.

MB: So can you just break that down a little bit further. So, you said about structural reform. What do you actually mean by structural reform?

RSF: So many structural reforms have the same origin, in that European regulation, bureaucracy, over the years, has managed to do a lot of harm to the economy. Harm that wasn’t necessary, harm that we invented ourselves, inflicted upon ourselves.

And so, if we were to be able to remove this harm via structural reforms, it would give Europe a much better chance of growing, mobilising capital that is already here, that is available, but that is being held back by barriers that Europe created. And so, a number of these initiatives that Draghi identified and that are now being worked on are in the financial sector.

And why is that? Because the bank lending in Europe has such a dominant role. Bank lending stands for 70% of all funding requirements of Europe, with either debt or equity funding. We just don’t have enough of a developed capital market, just don’t have enough of a venture capital or private equity culture, so bank lending plays a crucial role, and bank lending has become very expensive, mostly due to regulation.

And so, the thinking is if we can ease the conditions under which bank lending takes place, it will get cheaper and more funding can be distributed. And the good bit is the funding, as such, the capital required, is already existing.

MB: So, the reforms are one part but the other part, and I mentioned Germany at the very beginning, the stimulus package there is approximately what, €630-odd billion. That’s going to be significant, isn’t it, to the future of what Europe looks like?

RSF: Yes. So, there’s two bits going on in Germany. One is the infrastructure and defence package, which is government funded. It’s €500 billion each, over a 10-year period. But the problem is this requires actual raising of that in the capital markets.

And then there is the private sector initiative, committing €630 billion over a much shorter period of time, from 61 private companies, which would, when you do the math, crudely implies about a doubling of the pace of investments of these companies, which is very meaningful. But, on the EU level, things like the securitisation market reform, the reform of the equity requirements for banks and how much capital they need to hold, could unlock capital that’s already existing, that is just being held back.

And that would be much more impactful. So, in terms of magnitude, the big structural reforms would be much bigger than what’s going on in Germany. And they have the additional charm of not requiring any interest payments on it.

MB: You mentioned Ukraine just at the very beginning, and I also mentioned it when I sort of. Talked about one of the big challenges in Europe. But if we sort of look into the future and let’s, let’s assume a form of resolution or post-war situation for Ukraine. What sort of role does Europe play in that? How does that change the investment outlook, you know, in the coming years ahead?

RSF: For one, I think if there was peace in Ukraine, it would lift a big weight off the European market, as such. We have underperformed in 2022 as a market quite substantially because the Ukraine war broke out. And this multiple loss has never been made back. So there could be a good speculative, but 15%, maybe 20% catch up trade for the European market as such just from lifting that valuation multiple.

When we drill down a little deeper, where do the investment chances lie, specifically. One very clearly is defence. Why? Because Donald Trump’s already said that in any post war Ukraine scenario, peacekeeping force will not be provided by the US but would have to come from Europe. The estimate ranges between 50 to 150,000 troops.

If we take the typical equipment numbers, it would, for instance, require the transfer of somewhere between 40-90% of the entire European main battle tank fleet to Ukraine to maintain the peace in any post-war scenario. That’s obviously a huge, huge number, so there would be substantial investment needs in defence. But then we would also have the positive aspects, the positive aspects of a rebuild, and that rebuild would be financed by Europe. It would be the European banks that would benefit.

Why? Because it would be the Polish builder crossing across the border. It would be the Slovenian/Slovakian companies. It would be the Romanian companies going across, driving that rebuild, building the roads, rebuilding railways, power stations, what have you.

And so, they would all need more working capital, finance, maybe finance another car, um, maybe finance another warehouse and so on and so forth. So, for the banks, it would be a boom. The Eastern European-exposed banks in particular, and then construction materials, in many cases, these products don’t travel very well, so it is less of a concern of them being displaced by, say, Chinese imports and so on. But it would dramatically tighten the supply demand balance for construction materials in the central European region. So for these companies, it would be a proper plus.

MB: I’m interested when you said about that the materials aren’t travelling so well, so that almost protects Europe to some extent. What sort of materials don’t travel well? What? What are you looking at then?

RSF: If you think of the basic products like steel, but it could also be particular; say that steel gets moulded into railway tracks, or it could be glass or bricks. The typical heavy construction materials, usually they have a radius of a few hundred kilometres from the factory of origin and otherwise becomes uneconomical.

Now that radius might extend, because there is not much production capacity left in Ukraine, but in the Central European region, we typically have excess production capacity in these areas. And so that would tighten the supply demand quite drastically.

MB: So you’ve mentioned a number of sectors that would benefit from this hopeful post-war, Ukraine. So banks, defence, construction materials, that sort of space. If I broaden it out now to include the rest of you not associated directly with the war, but other sort of potential places that you’re looking for. Is there any other sort of sectors that interest you right now?

RSF: Yeah, there’s a number. For instance, telecommunication used to be a graveyard for investors. For a long time, was guaranteed underperformers. And what is changing is that the Competition Commissioner Margrethe Vestager has been replaced. The replacement seems much more open for market consolidation. And then the chief bureaucrat of the Competition Commission, also a longstanding hawk, has retired and has been replaced as well.

Seemingly a much more moderate replacement. Indeed, the message seems to be to the companies in the sector “come and test us”. And so, we are seeing a significant potential for market consolidation, market repair in that sense, for European telecom operators. Let’s not forget Europe stands out and that it has more than 45 major telco operators. When we compare it to similar sized economies: US four, India three, China three, Europe – over 45.

MB: How do you pick a winner from all of those?

RSF: We tend not to not to target the takeover targets, because these companies are quite binary in outcome. But we tend to stick with the big companies because the main thing that would change, so if the European markets lose, on average, 1 to 2 competitors in each of them, the main thing that would reduce is the customer churn. And the main cost for these companies is customer churn. The rebates they need to give to acquire or reacquire these customers from intense competition would drastically shrink. And so, for them, it would go from a business model that typically earns below the cost of capital, to something they would likely earn above. And the stocks are still valued as if they will be value destroying forever.

MB: So for our listeners, there’s a number of sectors you’ve talked about that are exciting. Some are conditional on an end to the war in Ukraine, but others are not. So, for investors who are sort of really considering making that allocation into Europe, what else? Let’s take the other side of it. What risks should they be looking out for as well?

RSF: Well, the main risks I think are delays in the structural reforms. We’re fairly confident in the securitisation market reform and in the reform of the equity capital requirements for our banks. There have been concrete steps, public. They’re transparent, but it always requires, in the end, a political decision.

Now, in the securitisation market reform, it requires a European Parliament decision, and it requires a decision by the Council of Ministers. In the form of the capital requirements for banks, it might be easier because it doesn’t require political interference. It’s a regulatory topic. The politicians put pressure on the regulator to consider not just financial market stability, but also international competitiveness and macroeconomic growth. And so that decision is more independent of political cycles.

But political risk remains high clearly in the reforms. Over and above, we have, of course, the political risk as such in general. I mean, France is heading into yet another difficult budget season, potentially with soon a new prime minister. One way or the other. We’re seeing tax demands rising. The situation of public finances generally is not great.

We have that in the UK, but also in other parts of Italy, France/ We had banking taxes being speculated about in the press in recent weeks. So there’s many risks from a political side that need navigating, that need manoeuvring/ We are for instance, in our strategies, we let exposures breathe up and down, accordingly, we take some profits, manage the risk actively. And then, the wider overhang is, of course, will Ukraine get resolved or not, the tariff situation with the US seems largely resolved, but it’s also not a final trade deal.

So, things are potentially open to change. And we know the new US administration certainly hasn’t been averse to, changing things if they feel the need to. So that’s a lower probability but potentially high impact event.

MB: I’m basically going to quote you now from the very beginning of the podcast, which was that Europe’s at a crossroads. So, if you had to summarise all of this into one sentence, the opportunity in Europe right now, what would you say?

RSF: The opportunity is vast. Why? Because the structural reforms have a potential magnitude of 20% of European GDP, which could be unleashed from capital that is already existing. So, the market that hasn’t grown in years, the economy has stagnated; is not priced for that kind of potential growth. So, the opportunity is vast. The risks, I think, can be mitigated. In the worst case, we’re completely wrong. I don’t think investors risk to lose much money. But there is so much to play for.

MB: So, the opportunity is vast. Risk can be mitigated. And if it’s wrong, there’s not a lot of downside.

So, Robert, we’re out of time. But thank you very much for all of your thoughts. And also I want to thank our audience for listening. Of course, if any of our listeners wish to learn more about Janet Henderson’s investment views, or if you have any other questions, then please don’t hesitate to contact your client, relationship manager or visit our website.

So with that, thank you very much for listening and I wish you a very pleasant rest of the day.