Proponents of ‘sell in May and go away’ have so far been vindicated in Europe, with a broad range of leading market indices down thus far in June. Nervousness around Greek debt negotiations and recent heightened volatility has caused some investors to bank profits. However, while the lower trading volumes synonymous with a European summer should contribute to further short-term market turbulence, the factors causing much of the volatility should ultimately make way for what remains a strong fundamental story for European equities.
A blow for the bund market
Germany’s recent bund fall (a loss of 7.4% in the 7 weeks to the 10 June) is in part explained by an improving European economy and rising inflation expectations – no bad thing for small corporates in Europe. But there is an argument that it was also caused by speculative money. Investors poured into bunds ahead of the European Central Bank (ECB)’s quantitative easing (QE; asset purchases) programme, in the hope of capitalising on any shortage in government bond supplies, which helped to push up prices. Recent weeks has seen some of this unwind and, as is often the case with these crowded trades, it has been vicious.
The risk of crowded trades
Similar crowding occurred in the DAX – the leading index of German large cap stocks. The ECB’s accommodative monetary policy, a combination of interest rate cuts and the much-heralded QE, saw the euro weaken sharply versus the US dollar and encouraged investment into the DAX due to the international exposure of companies in the index and US dollar-denominated revenues.
While not a crazy strategy, a small reversal in the currency, due to weaker economic data in the US and further strength in the European economy, saw the DAX fall by approximately 11% from peak to trough (10 April 2015 to 9 June 2015). Comparing the performance of European small caps over the same period, a rise of 3.6% confirms what clients have been telling us: that, after a difficult 2014, investors now have limited exposure to smaller companies. I find this encouraging, given the potential for investor allocations to increase.
Reasons for optimism
In simple terms, European smaller companies are a play on economic growth, both in Europe and globally. A number of economic indicators are looking positive and point to expansion. There have been earnings upgrades for the first time since 2011. In fact, European small caps are now forecast to deliver over 16% in earnings growth in 2015. That should attract more attention in what remains a low-growth world.
The argument is further supported by the pick-up in merger and acquisition (M&A) activity, with corporates taking advantage of cheap credit and cash-rich balance sheets. This activity remains concentrated at the lower end of the market cap scale, with 69 of the 83 deals announced thus far in 2015 in the €1bn to €5bn ‘smaller cap’ range.
Merger and acquisition activity finally picking up in Europe
Source: Henderson Global Investors, Bloomberg, as at 7 May 2015. Indicates European M&A volumes. Deal value and deal numbers refer to Western Europe.
In our portfolios, YOOX, the Italian internet mail order clothes retailer, announced a merger with Net-a-porter. YOOX's share price jumped by more than 30% as investors warmed to the potential of the deal – complementary business models; a dominant market position in a fast-growing channel; significant clout in dealing with suppliers and customers; and a global footprint and supportive brands.
Harnessing consumer demand
So which areas do I favour? I’m currently finding stocks benefitting from the domestic recovery attractive, such as asset gatherers Anima and Fineco bank in Italy. These are solid franchises with excellent distribution channels, and Italy is arguably the European country seeing the most economic improvement following a number of reforms by Matteo Renzi’s government.
I am also comfortable with having selective exposure to consumer-related areas in Europe which are benefiting from a weaker oil price and tighter labour markets – when the demand of the labour increase relative to demand - although unemployment remains too high on aggregate. Nobia, the kitchen manufacturer, for example, should benefit from growing consumer demand following its restructuring.
Higher valuations and sentiment-driven swings can make investors nervous, but fundamentals hold up. In a world where growth is scarce I believe that the appeal of smaller companies will only increase over time.