Moving towards the midway point in 2016, the year thus far has been far more volatile than many expected. Politics remains the main concern as Brexit temperatures rise in the UK, Spain has called new elections for end of June, and the general widespread criticism of politicians continues unabated. Recent elections in Germany have confirmed the growing dissatisfaction with Chancellor Merkel's approach to the refugee crisis, while more dynamic attempts at labour market reforms in France were met with the expected hostile reaction.
At this point it would be encouraging to focus on the positives for European assets. These include quantitative easing, relatively low valuation levels compared to other developed markets, the potential for corporate profit margins to recover, and attractive income yields on European stocks. Meanwhile, in the 'real' world, economies in Europe are making gradual slow and sedate progress. Unemployment is down, manufacturing indices are holding up and the recovery seems generally 'satisfactory', although this is admittedly an altogether tame summary of the economic situation.
More broadly, the global debate continues to rage about how strong economies really are. Just as Europe is recovering China seems to be slowing, with both exports and imports falling, and corporate profits down. One solution to kick-start growth in the region would be to devalue the renminbi, effectively draining growth away from other regions. This could well risk any further recovery in Europe, putting particular pressure on some of the more heavily indebted peripheral European economies, such as Greece. Whether or not we see this scenario unfold will ultimately be politically dictated, given that China is a command economy.
In the US there is a growing feeling that the US Federal Reserve (Fed) will tighten monetary policy again during the summer, but probably not in June – although a single set of data might change that view. US companies have become accustomed to borrowing at historically low interest rates, and normalising interest rates may prove more problematic than the Fed would like to admit.
Europe remains fundamentally mispriced
It would be simple to look at recent geopolitical uncertainty and surmise that, at least for the time being, European markets are in somewhat of a no-man’s-land. Aside from the merry-go-round of political uncertainty, a recovery in corporate earnings is long overdue for this stage in the cycle. Corporate first-quarter results were roughly in line with subdued expectations and the majority of firms reiterated their previous full-year expectations, leaving nothing for short-term bulls or bears to get their teeth into.
While such uncertainty seems to have prompted many investors to delay any potential decision on investing in Europe, we think that now is a very good time for value in the region. If you look at the Schiller price/earnings (P/E) ratio (see table), which is the 10-year cyclical adjusted P/E from the market, Europe as a universe remains one of the cheaper developed markets:
Source: JP Morgan, as at 31 March 2016. LT – ‘long-term’.
The Brexit factor
On a pan-European basis, we are of course playing close attention to the upcoming vote on the UK’s membership of the EU, where the level of debate has deteriorated to embarrassing levels of claim and counter-claim, with a consequent impact on market sentiment. The outcome of the UK referendum seems finely poised. Logic, economics, experts and external observers all suggest that the UK will remain part of the EU, but the populist backlash led by former Mayor of London Boris Johnson is finding favour with some. A vote to come out of the EU could cause a sharp fall in UK markets and sterling, but would probably also harm all of Europe.
In reality, this kind of uncertainty can often create a good entry point for value-focused investors like us. Uncertainty tends to lead to an increased risk premium, as people put off making investment decisions in the hope that markets will settle down later, or opt for safe haven alternatives such as government bonds or high-quality growth stocks (where there is often a premium for safety). At the moment, it does not look like the concerns about a potential ‘Brexit’ have been severe enough to create that much value. Should market volatility continue and stock correlations weaken, this will create pricing disparities, offering a potentially rich vein of opportunities to invest in quality companies on attractive valuations.
Across European markets in general, we are very dependent on the quality of publicly available information. This means that we tend to avoid the more peripheral markets, such as Poland, where the level of detail on individual companies can be limited, or less reliable. At present, the strategy is slightly more overweight in France than in Germany, and has moved overweight in Spain, relative to where it has been in the past.
Within the core European markets, we are finding opportunities broadly speaking across the board. We tend to invest where we believe that the market has fundamentally mis-priced what we see as a good quality company, either on perception of a specific risk, or broader market uncertainty. Key purchases in 2016 thus far across the strategy include Deutsche Post, Sampo, and Siemens. Using Deutsche Post as an example, this is a stock which we had previously sold on a full valuation. Recent concerns over Amazon’s plans to open its own parcel delivery depots appear overdone, while the yield also looks attractive. In summary, and in line with the current discount to other developing markets, we are currently finding compelling reasons to be positive on Europe from a value perspective.