Opportunities in European equities

Q The revival in European equities has been one of this year’s most persuasive stories, which private clients and institutions have embraced. What are the reasons for this?

A Indeed, it looks astonishing. Until  recently, people were very concerned about systemic risk associated with the eurozone. Europe faced a shock and made reforms as never before. Countries in peripheral Europe have implemented massive reforms, cutting labour costs, which helped improve their current account and trade balances, which has had an impact on employment.

Governments took drastic austerity measures but gradually they have appreciated that the pressure on people and economies is far too high.

The rise of the populist vote in the last European election has made governments realise they need to relax the fiscal drag a little. This should help increase consumption and corporate spending.

Also, the European Central Bank (ECB) has been quite pro-active – although maybe not as much as the Bank of England with its Funding for Lending scheme, which helped the UK recover quicker than the continent.

But the ECB’s decisions have been in favour of continental Europe, starting with the first long-term refinancing operation (LTRO) at the end of 2011 and more recently with its ambitious package of measures, which surprised most investors. These will hopefully resurrect the dysfunctional credit mechanism in Europe, which is key for the region to recover further.

Some markets, such as the UK and Germany, are in better shape. Some peripheral countries, such as Spain, Ireland and Portugal are catching up. Others, like France or Italy, are lagging behind, because they haven’t reformed as much. But they are all moving in the right direction. The momentum is still there and the region is attractive for investors, especially compared to other markets.

Q What sort of effect will these factors have on stocks, and small caps in particular? Do you feel these are more likely to outperform the larger companies, bearing in mind that funds in the European large cap growth sector have outperformed all other styles over the last five years?

A Small caps are very attractive to me, especially in developed markets. Detractors say they are more volatile than large caps, but in fact in developed markets, small caps tend to outperform large caps over the cycle.

This is particularly true when the economy is recovering and accelerating, as in Europe today. And there is good reason for that – it is true that the growth style in Europe is outperforming, and among small caps there are a lot of growth stocks. The small cap universe is very big, much bigger than the large cap one, and therefore it may be difficult to analyse. The coverage is not so good, but if you do your homework you can find a lot of growth stories.

This is due to the fact that small caps usually tend to have a high capital expenditure, significantly higher than their large cap counterparts. This means higher growth expectations, which translates into higher company profitability and higher returns.

Q People talk about defensive or cyclical stocks. Are there any other key factors stockpickers should be trying to identify at the moment?

A In the phase of the steepening of the yield curve, cyclicals usually do well, so you could have some cyclicality in your portfolio in addition to more standard growth stories. Small caps are attractive for another reason too – this year large caps have the ability to borrow money more easily than small caps, they can access financing cheaply, as corporate bond yields and interest rates are very low, or have cash. They use this money to make acquisitions – M&A activity has significantly resumed – and they target small caps, local niche players, who are more sensitive to the European recovery. This is another element which makes small caps attractive, and one people can easily play.

Q The ECB’s package of measures, announced by Mario Draghi at the beginning of June, is seen as a key determinant in the future performance of equity markets. But we can look at this as a positive shot in the arm or we can say keeping rates low and signalling asset purchases shows a deep concern about the eurozone’s economic weakness. How would you look at these measures – ones we should be concerned about or ones which will have a positive impact?

A It is always the question of the glass half full or half empty. The economy is not growing so much and that’s a reason for concern. Considering the ambitious plan of the ECB’s last package of measures, you may say it is because the state of the economy is very poor. I think it is just showing the ECB is determined to get this situation fixed and there is no time left.

The ECB has to have ambitious plans, like this one, through which it is trying to re-ignite the dysfunctional credit mechanism; banks can now have access to cheap financing but will not deposit the money back at the ECB, because real interest rates are negative. Every economy needs credit, but in Europe around 80 per cent of the economy is financed by banks, versus 20 per cent in the US. On both sides of the Atlantic regulation has become tougher for banks, which are required to have higher and higher equity in their balance sheet. But if an economy depends largely on bank financing, that just kills it, because it prevents banks from lending.

This may be one of the reasons why the US has recovered more quickly, because corporates there can get money more easily by issuing corporate bonds for instance, which is significantly less common in Europe. 

Q Will this re-ignition result in a renewed upward trend or do you believe equities are perhaps too expensive and, some say, even displaying bloated valuations for the longer term?

A I think it will have a serious impact. If Northern European banks – which are the best positioned in terms of financing – instead of giving back the money they borrowed through the LTRO to the ECB,  were to lend it to Southern European banks, this may help. Securitisation is locked and it needs to be brought back to life.

The European equity market has gone up since September 2011, it is no longer  good value, but it’s the same in other markets. Concerns about valuations apply to other markets too.

In absolute terms it is difficult to assess whether equities are expensive. If you look at the MSCI global index versus the global GDP in nominal terms, for instance, and you analyse the trend of this ratio as you would do for a PE ratio, over past decades, you realise the global equity market is very cheap. Last time markets were at these depressed levels of valuation, it was the late 1970s and the beginning of the 1980s, but the context was different then, as inflation was high.

The risk today is more that of low inflation, which is definitely a headwind for the European recovery in this low growth environment. But I don’t think we will see deflation, as wages in Europe are not going down (on average). Hopefully the measures the ECB has taken will help credit flow again, but it will take a few quarters to see the impact on inflation and growth.

Q Are the main risks on the horizon coming from the geopolitical side, from China, Iraq and Ukraine perhaps?

A Definitely, and this is something that it is difficult for an investor to control. The civil war following the annexation of Crimea by Russia scared people. But after months of crisis, although nothing is under control, it’s more a case of negotiations between Russia, Ukraine and Europe.

At this stage, I would be more concerned about the situation in Iraq, which is critical, and the risks coming from China – be it in the China Sea or on the Chinese property market – where there are sensitive political issues, difficult to appreciate from Europe. Hopefully they won’t escalate too much.

Q Do you think there is more scope for European equities to outperform relative to US stocks?

A I think so, simply because the US is far more expensive by every standard than Europe. The growth expectation in the US is well priced in. Despite that, you can have hiccups like you had in the first quarter.  Valuation is quite rich, and even the International Monetary Fund (IMF) seems to now be sceptical about the sustainability of the growth going forward.

In Europe, however, there is room for growth to surprise on the upside and this is not priced in yet. The ECB is keeping its foot on the accelerator and will certainly decouple from the other central banks at some point. Improving growth and lasting accommodative monetary policy should definitely help this region and make it more attractive than the US. 

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