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 11th-hour wrangle so 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 – have been able to fly kites, suggesting that tapering of the region’s huge 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, albeit slowly, 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. The key thing for both 2016 and 2017 is that there is a rich seam of “5% to 10%” growth across multiple other sectors and within individual stocks.
And it is here that the problems have arisen, because that “rich seam” has been extensively exploited over the last three years, leaving 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. Since most companies invest for the longer term, there will always be slower periods, especially with uncertainties like the rancorous US election and Brexit, and 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 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 that 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.