Finding safety in the slump

Europe is very much a two-speed economy. On the one hand, there are the core European countries such as The Netherlands, Germany and France which are relatively attractive because the consumer is less indebted than his counterpart in the US. On the other, there are those countries such as Portugal, Italy, Greece and Spain, latterly clumped together under the somewhat pejorative phrase Pigs, which are suffering much more from the credit crunch and from having to stick with the euro. The UK might also fall into that group, save its ability to devalue its currency, and on a trade weighted basis over 12 months the pound has fallen 33 per cent. Staying underweight “Germany, Holland and France are in better shape because their consumers are in less trouble, there is less wage inflation and the Government sector is not as indebted as the Pig economies,” says Paul Whyman, senior investment manager at Fortis Private Banking. “The problem is that if the UK needs readjustment at a macro level, the currency can take the strain but the Pig economies have to take the pain in the internal sector such as with wage constraints.” Most analysts and economists are advocating being underweight in Europe because they believe the US will lead the way out of recession. Looking at average valuations on a 20-year basis, then the US is currently on a PE of around 13.8, down from 17 at the market’s peak, far more oversold than European markets which are now on average PE of 8, compared with 14 at their peak. Mr Whyman, who looks across all markets, says he is underweight Europe because although the region was late into the slowdown, it is not highly resilient and the ECB has also been behind the curve in reducing interest rates. Government initiatives “Arguably the slowdown in Europe will not go so deep and the high level of social security will help stabilise the economy,” he says. “But Eastern banks are heavily dependent on overseas capital and so a lot of Continental European banks put money in these areas and now those banks have a problem,” explains Mr Whyman. Government initiatives across Europe may have unleashed a vicious cycle where the remedies to the financial turmoil - the bank bailouts and stimulus plans – have created a backlash that could worsen the crisis. Economic hardship and rising unemployment have already sparked protests in Greece, Bulgaria, Latvia, Lithuania, Madagascar, France and Russia, and protracted demonstrations helped to bring down the government in Iceland. Protectionism could worsen and stoke instability. The mood amongst British workers, for instance, is becoming uglier in relation to the use of foreign contract workers. The big macro debate is whether the deflationary argument will win and markets suffer further or whether the fiscal policies will be sufficient to revive the economy. Debbie Boys, head of the Europe equity funds sector at Standard & Poor’s Fund Services, says that many fund managers are very bearish, believing that earnings forecasts will continue to shrink and that the bad news is not fully discounted. “It’s a more tactical market, and fund managers talk of having to be far more alert to newsflow,” she says. Nowhere to hide “I’ve never seen such personal fear in the markets,” Ms Boys adds. “It’s difficult to find a place to hide. It’s hard for fund managers to swallow their losses, stand up and look as though they are in command when what they are feeling is: ‘What the hell do I do now?’” Tom Stubbe Oulsen, manager of the Nordea-1 European Value Fund, is not too concerned about weightings in individual countries but he believes that the UK is the hardest hit by the credit crisis and difficulties in the property and financial sectors. “We’re wary of the addition of public debt and the danger of inflation and these concerns are already at least to some extent reflected in the currency,” he explains. “We may see continued weakness of the pound, but a lot of the damage has already been done,” he says. “The fact that other European countries do not suffer from the UK malaise does not itself make them interesting,” Mr Stubbe Oulsen adds. “Germany has no problem with the property market, for example, but it has still been hard hit because it is such a big exporter. These things ripple out like rings in water.” A common complaint is that the market has not been differentiating between good and bad stocks. “The macro-economic data is still poor, but sometime in the second half of the year there should be a return to valuation basics and good stock-picking will again produce alpha,” says Miguel Corte-Real, investment director at Fidelity. “We think we’re somewhere near the bottom and strong measures by different governments, especially the US, will have an effect, but rights issues, such as Xstrata’s recent £4.1bn (E4.6bn) fund raising, will become more prevalent exacerbating market volatility in the second quarter,” he says. The Holy Grail in this climate is companies with super-strong balance sheets. Mr Corte-Real likes Munich Re, for example, which he says has pricing power as insurance companies try to reinsure their risks and the number of hedge funds prepared to take on these risks has contracted. He also likes pharmaceutical Roche, which is well positioned in oncology, and utilities such as Eon. The big differences in performance between funds over the last six to 12 months are the result of the managers’ varying views on just a few sectors. The Fidelity fund was overweight in financials in the third and fourth quarter of 2008, but Mr Corte-Real admits that with the benefit of hindsight this was premature, and adds that fraud cases such as the Madoff scandal could not be anticipated. He is still confident of a recovery within 18-24 months. Sensitive stocks The Blackrock European equity fund was switched into consumer discretionary and healthcare last summer, then into industrials and energy-related stocks in the third and fourth quarters, and manager Nigel Bolton is now turning his attention to stocks that are sensitive to the cycle. “Consumer staples and pharmaceuticals are where our competitors are hiding at the moment, but we think very defensive portfolios are just the wrong thing at this point in time because that means getting in at the nadir of the economy,” explains Mr Bolton. “What we did in the second and third quarters last year was a big change,” he says. “We saw real value in energy and mining stocks where there had been under-ownership in the market. “Now industrials may be at rock bottom. The materials sector is on 20 to 30 year lows, and we now see real value in these depressed sectors - an 180 per cent change on our position last year,” says Mr Bolton. “The question is whether they have the balance sheet to swim, strong cashflow and good managers with the ability to control capital.” The MFS Investment Management team was overweight in pharmaceuticals three to four months ago and took profits. “Pharma has done well by virtue of doing nothing,” says Barnaby Wiener, director of research at MFS Investment in London. “We still like Bayer and Novartis on a relative valuation call, but have long term concerns about the sustainability of growth with the deterioration in drug prices in the US and patent expiry issues,” he says. More recently Mr Wiener’s team has increased the fund’s exposure to telecoms such as Vodafone and Dutch semi-conductor company ASML, a clear global leader with 50 per cent market share that is investing heavily in research and development. Searching for strength Mr Wiener says his team is trying to identify companies with strong balance sheets that have been heavily sold off and are attractive relative to their peers. For example, Swiss luxury goods company Richemont has fallen roughly 50 per cent since the middle of last year but remains profitable, and German professional software company SAP, a market leader with a healthy balance sheet. In the banking sector, MFS has been trying to position themselves in stronger banks with reduced balance sheet risk, selecting Julius Baer, the fee-based private bank and wealth management business, and UBS, where they believe the private wealth arm alone is worth the current share price. Another big story is the selection of stocks with global revenues. “Six months ago it was obvious the pound was going to be in this position, so we are hedging by buying companies such as Vodafone which have most of their sales outside of the UK,” explains Mr Corte-Real at Fidelity. “There is a real need to understand exactly where sales are coming from and who the local competitors are.” He also holds Teva, the generic pharmaceutical listed in Israel, which has fairly global revenues. “The problem with Europe,” adds Mr Corte-Real, “is its lack of leadership in terms of policies. We have to look to the US as to what to do next. Normally the US tends to be first in and first out and Europe is more resilient but this time everyone came down at the same time. “We think if you buy quality companies with good products and international growth, then sooner or later they will come through. The risk is how long Tarp 1 and Tarp 2 will take to feed through to the real economy,” he explains. Value back in style European fund inflows have benefited from the flight to conservative investments, particularly by US investors. “The value style was hit badly in the downturn but the long-term approach of value funds may be something that is now coming back (into vogue),” says Mr Stubbe Oulsen at Nordea. “In times of uncertainty, people are looking for something more tangible or fixed to hold on to and Value is likely to do well in a recovery.” “The inventory cycle was a big negative impact in the fourth quarter and again in the first quarter, but the economic statistics may start to look better in the second quarter,” predicts Mr Bolton. “It’s as though the deleveraging pain is now finished and out of the way and we are waiting in a gorge for new statistics to come out. We will start to see clues in the second quarter, perhaps more investor confidence and allocation of the large cash piles that have been building up,” he says. “The impact of the big interest rate cuts and fiscal stimulus will start to show and there is evidence from China that bank lending is moving again. The thing to think about is how the environment will be in 6 to 12 months. Running a portfolio through a recession requires you to look through the dip,” says Mr Bolton.