European equity markets have hardly been a relaxing ‘buy and hold’ investment for the last few years. In 2015, global investors rushed in and bought Europe in anxious anticipation of the long-awaited recovery in European economies, spurred on by the European Central Bank’s quantitative easing (QE) programme. By early 2016 it had become very clear, as we warned mid-year 2015, that those earnings would not recover by anything like as much as expected. The ‘recovery’ trade faded, European markets drifted and then underperformed sharply as political risk rose after Brexit and ahead of the busy electoral timetable in 2017.
The perverse thing about the sell-off in Europe, at least on a relative basis compared with other markets, is that from mid-2016 it was becoming clearer that Europe’s economic recovery had finally begun. In early 2017 it is actually looking very robust, with unemployment falling, investment recovering, consumer demand strong and governments no longer as financially strapped as they have been for the past few years. In many ways a vicious cycle has become a virtuous circle. What’s more, that elusive earnings recovery looks like it has finally arrived: earnings have been forecast to increase around 10% in 2017 and, three months in, that figure has actually increased somewhat, rather than slashed – as had been the case in the last few years.
Politics – the persistent problem
The one simple reason that European equity markets have failed to show more encouraging performance in the light of this better news is politics. The surprising decision by the UK to vote for Brexit created the uncertainty, and the election of Trump has continued that trend of worries. With these two major areas, the UK and US, choosing to take an alternative route, it is inevitable that the UK’s partisan local press will try to make a case that voters have not made a mistake. Undermining confidence in any news story and branding any honest opinion as ‘Project Fear’ or ‘fake news’ will ultimately grind down the most persistent optimism. What is more, all observers and interested parties are understandably nervous ahead of crucial elections in France in April and May. We believe that the far right candidate Marine le Pen will not win.
Within European markets there has been a relentless period of rotation. Some of this is easily explained – mining was way oversold and China began to recover after significant stimulus, while metal prices rallied. The oil price recovered, benefiting oil companies that had outdone each other in their efforts to cut costs and improve efficiency. Cyclicals such as Atlas Copco leapt ahead in anticipation of a surge in profits in 2017 and beyond, moving many of them to quite demanding valuation levels.
The problem now is that there is a strong case that a lot of the drivers that supported a market rotation are now ‘in the price’. Some of the most expensive parts of the market are now engineering companies. Most pharmaceutical companies are at a discount to the market. Somewhere in between are the consistent and reliable growth names that were previously, in 2014 and 2015, the best-performing stocks.
Patience is the primary virtue
So does this mean that ‘quality’ will be the next area that the market will rotate into? The answer is – not necessarily. Firstly, banks should begin to show the improvement in profitability created by an improving economy (fewer bad debts) and better interest margins. So financials should continue to do well. Secondly, many of the infrastructure and investment-related names are at the beginning of a period of recovery in profits that should last for some time. Thirdly, corporate activity is picking up and merger and acquisition activity should thrive in this low interest rate environment.
The result is that it is not a question of growth versus value, or quality versus unpredictability. It probably remains more a question of patience. Ultimately, it is clear that the UK will not grow quicker as a result of being outside Europe, and that the US will not grow faster because of Trump’s Wall or tax cuts. The likelihood is that we stay in a world of low growth. In that world, patience is required, and a focus on long-term compounders: companies that can grow their business regardless of the economic environment. Given the rotation in markets, whether these should be seen as ‘growth’ or ‘value’ is a matter of perspective.