Gaining global reach without volatility

sA persuasive argument for investing in European funds is their diversification. Although the underlying economies are lumped together they are a heterogeneous group, with economies as diverse as Germany’s mammoth mechanical engineering industry and energy-supplier Norway, with its smaller population than Greater London. This spread offers relative immunity from the cash-strapped consumers of the US and UK, together with access to many truly global stocks. European companies frequently deliver global reach without the full volatility of pure emerging market plays. Cedric de Fonclare, who runs Jupiter European Special Situations fund, says Europe has been the main beneficiary of globalisation because low growth in domestic markets in countries like France and Germany created an incentive for companies to expand, and they have also been able to take advantage of immigration from Eastern Europe which has lent flexibility to otherwise rigid labour markets. The European fund umbrella further diversifies risk away from the overstretched consumer of the UK, and to a lesser extent Spain and Ireland. In Germany, for instance, 10 per cent of monthly income finds its way into personal savings. Arguably, it was stronger household balance sheets across the Continent that allowed the European Central Bank to get to grips with inflation in July, raising the rate on the marginal lending facility by 25 basis points to 5.25 per cent. “At the moment the big fear is that policymakers in the UK and US are so constrained by high inflation that they can’t act to help the economic outlook,” says Raj Shant, manager of Newton’s Continental European and European Higher Income funds. “It may seem perverse to say so, but the European Central Bank (ECB) is doing a terrific job by raising rates,” he explains. “In Spain or Ireland you might think this was insane, but inflation is the key issue and it’s been part of the equity market reaction since the credit crunch last year. Inflation will begin to moderate and I believe we’ll see 12-18 months of growth in Europe, albeit at a slowing rate.” The ECB’s rate rise divided the market, however. “From a sentiment perspective the US Fed has been acting aggressively to defend growth whereas these guys at the ECB are myopic in their adherence to policy and attention to short-term inflation data,” argues Luke Stellini, product director, European Equities at Invesco Perpetual. “We now know GDP second quarter numbers were in negative territory. In my opinion raising rates was a mistake, a blunder that (Jean-Claude) Trichet’s subsequent hands-up speech seemed to acknowledge. I’m not convinced there need be such a firm hand against wage inflation,” he adds. “The way I’d describe the market at the moment is a real state of flux,” says Mr Stellini. “The commodity breakdown and dollar recovery have marked a line in the sand.” The unwinding of ‘long oil/short banks’ positions temporarily buoyed the market in the second half of July and helped alleviate fears of rising inflation, and a strengthening dollar also reduces the appeal of commodities. But it is too early to determine whether investors are abandoning commodities or just taking profits, and managers are still hoarding cash until visibility improves. Banking woes As we went to press, the financial sector continued to be hit by rumours about the state of Lehman's balance sheet and the prediction from former IMF chief economist Kenneth Rogoff that a large US bank will fail in the next few months. Some managers are picking off stocks such as BNP and Crédit Agricole with a slightly different model that they feel may be oversold. One country where banks have done fairly well is Italy. “Whether it is a lack of business acumen or down to great foresight or wisdom, most Italian banks have not invested much in subprime toxic waste,” says Philippe Brugère-Trélat, lead portfolio manager on the Franklin Mutual European Fund, adding that banks such as Intesa San Paolo and Banca Popolare Italiana “enjoy the benefit of a strong and very profitable domestic retail banking business”. The Henderson Pan-European Equity fund’s relative success over the year is partly a result of its underweighting in banks. Bill Stormont, who supports manager Tim Stevenson at Henderson, points out that other managers have acted on false signals that the banks have hit the bottom and could be about to recover, citing JPMorgan’s purchase of Bear Stearns in March and the UBS rights issue “where the hope in the wake of a results or other major announcement was that the bad news was out of the way. “We’re not prepared to guess at this when the banks’ own CEOs aren’t able to tell us when the next data point will be, so we are standing back until the valuation argument is in their favour,” says Mr Stormont. Although the materials sector has been sold off in the last month, Miguel Corte-Real, investment director at Fidelity, where the concentrated European Aggressive fund is 52.7 per cent invested in materials, is confident the basic imbalance between supply and demand to build infrastructure in China and other emerging markets will remain high, pointing out that although Chinese exports are slowing, there is still huge internal demand. Data from China will be scrutinised for signals. “There is a certain amount of wait and see until the Olympics are over,” adds Stormont. “China is slowing but the issue is one of magnitude and speed. There are positive internal dynamics such as softening food inflation which will help discretionary spending, but there are ongoing electricity shortages and other issues that must be born in mind, and a strong dollar spike could result in a stronger renminbi,” he explains. “The biggest headwind we are facing right now is not only the slowdown in growth but the impact on individual companies from the banks’ deleveraging of their balance sheets, making loans more expensive,” stresses Mr Brugère-Trélat. “That is a problem for companies needing financing but industrial companies in Europe by and large do not have the need for borrowing they had 10-15 years ago,” he adds. Industry healthy “The industrial sector in Europe is in pretty good shape still – though obviously there are exceptions - and has been going through a long period of restructuring, reallocating their resources from lower margin, lower growth businesses towards higher margin, higher growth businesses, so improving cash flows and lowering their need for debt capital,” adds Mr Brugère-Trélat. The industrials sector is broad, and managers are avoiding capital goods which are economically sensitive such as Scandinavian engineers, and looking favourably at the defensive end of the market. Managers are on the hunt for large global stocks with a true global reach, particularly in Asia – names such as Holcim, Lafarge, HSBC and telecoms companies such as Vodafone, which recently surprised on the downside in Spain but is still considered well positioned globally. “We’re looking for large companies with strong and established balance sheets and interesting cash flows that may find it easier to find exposure to global growth,” says Mr Corte-Real. “Many large caps have switched their models to revenue generation in emerging markets and Asia, to a quite surprising level, and look dramatically different from the companies of 10 years ago, even though there are questions about how much these new revenue streams will slow down.” Fund managers are well disposed to the oil services sector such as contract drilling companies which are positioned to benefit from huge order books from the oil majors and are protected by a scarcity of good geophysicists. The agricultural fertilisers sector is also a popular play on food shortages and changing eating habits in emerging nations. Some 15 per cent of the Fidelity European Aggressive fund is in just two fertiliser stocks, Israel Chemicals and Yara. Volumes will return to equity markets in September after the thin volumes of the summer break. “Many investors are lifting their weightings in the US which is good for the markets,” adds Mr Stellini. “If we see any sign of stabilisation in housing that is also key, together with any other alleviation in consumer spending.” The market is looking for direction, and managers will be keeping an eye out for cuts in earnings estimates and valuation opportunities as stock is downgraded. “Companies are harshly penalised if they miss their earnings targets,” says Mr Stellini. “The ’08 downgrades are largely out but analysts had been predicting 15 per cent earnings growth for ’09 which is still far too optimistic.” Big Pharma could be one beneficiary if its steadily visible mid to high single digit sales growth is reappraised. Some telecoms are already cheap and yield more than euro zone bonds such as Finnish operator Elisa, which yields 8-9 per cent. Brugère-Trélat will even be keeping a watchful eye on the retail and hotel sectors. Earnings downgrades are also on the radar of the Goldman Sachs Europe Core Equity Portfolio fund, which has an active risk profile of 75 per cent bottom up and 25 per cent top down. “We are really fundamental in spirit but quant gives us rigour in how we construct the portfolio,” says Carolina Minio-Paluello, executive director and portfolio manager of the quantitative resources group at Goldman Sachs Asset Management. "Some of the factors are based on fundamentals such as value and others look at trends, the opinions of analysts and management behaviour.” In the past few months the manager took the decision to increase the rebalancing of the fund from a monthly to a weekly basis, and moved to trading algorithmically which allows it to remain more anonymous.” “The fund’s historic stock selection decisions have played out relatively well and its resulting diversification protected it last year at a time when quant funds were badly impacted by a commonality of exposures,” says Mr Minio-Paluello. While the geographical weighting of most European funds is a function of the stock selection, managers are cautious about the political and inflation risks in Russia. Fidelity’s Growth fund has a holding in Gazprom for example, and points out that its 51 per cent ownership by the state affords some protection. “TNK-BP and steelmaker Mechel and a number of other situations should give investors pause for thought, as Putin attempts to re-establish Russia as a force to be reckoned with,” says Mr Stormont. “This winter the Ukraine, Estonia and other Baltic states could also be potential targets. There are all manner of levers the Kremlin can pull.”