Politics and trade wars cloud European outlook

“It was only 12 months ago that Europe was the place to be: the euro was strengthening, the economy was improving, inflation was finally coming back and unemployment was coming down,” says Alistair Wittet, manager of the Comgest Growth Europe Fund, echoing the thoughts of many commentators.

A year later and it suddenly seems as if Europe is in trouble, beset by political uncertainty and a weakening euro. From Brexit uncertainty to the Italian election, Trump’s trade wars to the financial crisis in Turkey, the headwinds facing European stockmarkets appear to be mounting. 

“My take is that people tend to over exaggerate one way or the other,” says Mr Wittet, insisting not that much has really changed. “We are still looking at around 2 per cent growth this year, so not stellar but pretty much where it was last year.” 

Unemployment meanwhile continues to fall, and politically France and Germany look relatively stable, he explains, and are the countries which really matter. “Italy is always unstable. It just happens that this time we are focusing on it a lot more than we did in the past.” 

The outlook for investing in European stocks remains positive, insists Mark Denham, head of European equities at Carmignac, predicting profits are likely to grow for the second year in a row, albeit less than the mid-teens level seen in 2017.

“We expect profit growth of about 8 per cent, reflecting decent underlying momentum in the European and global economy. Leading economic indicators remain expansionary.”

Valuations are also appealing in a long-term context, he adds, with, for instance, the average dividend yield on European markets at 3.8 per cent, which makes for an appealing return in this continued era of low interest rates. P/E ratings, meanwhile are in line with 30-year averages despite a relatively improved earnings outlook, says Mr Denham.

But not everyone is so optimistic. “We are struggling with Europe,” admits Roelof Salomons, chief strategist at Kempen Capital Management. Comparing the region to the rest of the world it is possible to find more attractive valuations in emerging markets while growth in the US looks better, he says. 

“In Europe it always seems like two steps forward, one step back. There is always something. This year it has been Italy, which became an acute problem, and is now merely chronic.” 

Italy needs reform, as does France, while the Germans and Dutch need to spend a bit more, says Mr Salomons. “There is the eternal hope that eventually European equity valuations will rise to the same levels as the US, but I think investors now want to see more evidence of that. The ability is there, but there are just so many issues.”

In theory, the European recovery should have longer legs than the one in the US as it is not as far advanced in the economic cycle. Yet Europe does not operate in isolation. Europe could certainly continue to grow for the foreseeable future, says Mr Salomons as it still has lots of catching up to do.  “But the caveat is that there shouldn’t be a hard landing in the US. If there is, then all bets are off. You are back to the old habit of when the US sneezes, everyone else catches a cold.”

The weak earnings momentum in Europe is a worry for Hou Wey Fook, CIO at DBS Bank. Despite Europe’s healthy macro recovery in recent years, thanks to the ECB’s QE programme, corporate earnings have remained lacklustre, he explains, especially when compared to the US. 

“We believe this weakness is partly due to the low representation of technology stocks in Europe, which constitutes only 5 per cent of the STOXX Europe 600 Index – versus 26 per cent on the S&P 500 Index. This low representation would mean a major drag on aggregate earnings, as tech companies represent some of the fastest-growing firms.”

Europe constitutes a core part of the Singapore bank’s global multi-asset portfolios, and although it is underweight Europe from an asset allocation standpoint, there are definitely still opportunities, says Mr How. “In particular, we like Europe’s domestic plays, given that they will be less impacted during periods of rising euro strength.”

Trump’s trade wars

If there is one issue which appears to be threatening the health of the global economy, it is the growing spectre of a series of trade wars, sparked by Donald Trump’s insistence that the US is “being robbed” under the current system and his hardline method of tackling the issue.

President Trump has singled out both the EU and China in particular as taking advantage of the US and has imposed a series of tariffs, with both responding in a similar manner, and although the situation with Europe has cooled somewhat after Mr Trump and European Commission chief Jean-Claude Juncker met and managed to avoid an all-out trade war, considerable uncertainty still persists.

Investors are certainly worried. A Bank of America Merrill Lynch survey carried out in July found 60 per cent of global fund managers saw a trade war as the biggest risk to markets, and the $663bn funds they managed between them had cut equity exposure to its lowest levels since November 2016. Allocations to the eurozone have fallen to a net 12 per cent overweight, the lowest since December 2016. Emerging markets have also suffered outflows, although exposure to US stocks has risen. 

“Exporting nations are the main potential victims of this situation and as a result emerging and European equity markets’ performance has been suffering,” explains Antoine Lesne, Emea head of strategy and research at SPDR ETF at State Street Global Advisors. European investors have been gradually rotating into more defensive sectors such as consumer staples and healthcare, he reports.

UBS Wealth Management is one example of an investor which has downgraded its position on global equities amid trade tensions, believing markets have not fully priced in a fresh round of “tit-for-tat” tariffs.

“While we expect the trade disputes to ultimately be resolved before the world is tipped into another recession, our base case now assumes things will get worse before they get better,” says Caroline Simmons, deputy head of UBS Wealth Management’s UK Investment Office.

If the trade situation were to worsen there could be significant consequences, for example supply-chain disruption, reduced hiring and lower investment, she warns. UBS has downgraded its position on the consumer discretionary sector in Europe, and urges investors to become more global in their asset diversification and consider defensive, rather than cyclical stocks as these should withstand volatility better.

These tensions could all simply “fade away”, predicts Jeffrey Sacks, head of Emea investment strategy, at Citi Private Bank, and the fundamentals of the equity bull market are still intact, but “we have recently reduced the extent of our overweighting to equities, and that is largely due to the escalating global trade war”.

Growth in Europe remains quite strong, he says, although there was some first quarter weakness. “Earnings per share growth is comfortably going to be in the low teens level for the next 12 months and valuations looks inexpensive. It is only just above the historic average and Europe is at a more than 20 per cent discount to US equities.”

Citi is bullish on European banks, a sector which it believes is under-owned and in the middle stages of a multi-year recovery period, while dividends are proving attractive in the continued low yield environment.

Nevertheless, there is a risk that in the coming months there could be some tangible evidence of the trade situation worsening and starting to impact the global economy. “Given that we have an unpredictable US trade policy, we think that there could be further escalation.”

European car manufacturers, especially those in Germany, are one group expected to be hit hard should the trade situation worsen. Yet they are using the threat of trade wars as an excuse, believes Cesar Perez, CIO at Pictet Wealth Management. “Auto sales globally were slowing down before the trade wars,” he points out. 

Mr Trump understands taxes and interest rates “very well”, says Mr Perez, but he “completely underestimates the complexities around trade”. Nevertheless, the president’s stance appears to be playing well with his supporters in the US, and with the mid-term elections coming in November, there is little prospect of this all ending anytime soon. But Mr Perez does believe corporate America will lobby hard to bring this all to an end as they stand to be big losers.

One move that does appear to be playing out is investors moving money to the US. “They see it as a safe haven, because you have the support from the fiscal stimulus as well as superior earnings growth, and multiples have pulled back to around historic averages,” says Grace Peters, European equities strategist at JP Morgan Private Bank.

Indeed the US is JP Morgan’s preferred equity market, but the bank does see opportunities in European small-caps as well as in the tech sector.

One theme it has noticed in Europe is that strategic M&A activity has picked up, as firms across multiple sectors seek to restructure and simply their operations. This is in part being driven by the impact of disruptive technology, says Ms Peters, which companies must respond to or else get left behind. 

“We are seeing the total opposite of what went on over the past 10 to 15 years, where multi-national companies grew through moving into adjacent areas and expanding into new product lines and geographies. And that has left a lot of them exposed, because the rise of technology and disruption means you can’t fight on all fronts.”

One way management can respond is to simplify their businesses and recognise what they are really good at and where to allocate capital. This is very much a European trend, she says, as a lot of US companies have already carried out these adjustments, in part because shareholders have been more vocal there. 

Identifying companies which are about to carrying out this process, or even better, those which are about to do so, is a way of driving returns from European equities, explains Ms Peters, as analysis shows these stocks consistently developed alpha relative to their sector.

Nothing new

Fears over the future of the European economy may have resurfaced in recent months, but for Walker Crips, the long-established London stockbroker which has made a push into fund management, the region has been a worry for some time. 

“We downgraded our view on Europe last year, but have been cautious to say the least for quite a long while,” says portfolio manager Andrew Morgan. “It goes back to the eurozone crisis, and the ultimatum Greece was presented with a few years ago, and there has been no meaningful resolution to those problems. A benign economic environment has been papering over the cracks.”

Germany is a particular worry, he claims, pointing to poor retail sales and factory output, while any escalation in the trade wars would hit the country hard. And a poor outlook for Germany affects the outlook for the region as a whole, says Mr Morgan. Italy is also a worry, he claims, although France is a brighter spot as president Emmanuel Macron seems to have the country on the right path.

Nevertheless, when the next slowdown arrives, Europe is going to be extremely exposed, warns Mr Morgan. “Europe could not be in a weaker position going into the next recession, whenever that is.” 

Political headwinds

Worries over the outcome of the Italian election,0 when the biggest winners at the ballot box, the anti-establishment Five Star and the right-wing League parties, both euro sceptics and who threatened to plunge the eurozone into crisis, appear to have abated somewhat.

“The newly appointed government seems to have toned down the more drastic policy measures proposed when they were initially sworn in,” says Nikki Howes, investment associate at Heartwood Investment Management, with an exit from the single currency off the cards. Confidence may have been restored, but investors should remember the government was voted in on the back of its radical, anti-EU policies, and these could resurface if poll numbers weaken, she warns.

Lingering political uncertainties are one factor in DBS Bank’s underweight position in European equities, says CIO Hou Wey Fook. Brexit, the Catalan declaration of independence, and the Italian elections have all been a worry, he says. “It’s clear the rise of euroscepticism has engulfed the region. We believe these headwinds will weigh on market sentiment in the coming months.”

The lack of progress in the ongoing Brexit negotiations have clearly proved to be a big drag on the UK economy, but are also having an impact on the wider European stage, says Talley Leger, equity strategist at OppenheimerFunds. 

“A deal would help give clarity to investors. If and when the UK leaves the EU, it would remove a drag on the pan-European economy, and lift a source of uncertainty on eurozone stocks.”

VIEW FROM MORNINGSTAR: Investors seek quality in bid to weather storm

Despite the dual headwinds of European political vulnerabilities and escalating trade war fears, the MSCI Europe index has managed to deliver a small positive return of just over 2.5 per cent in euro terms in 2018 so far (to the end of July). 

Within this, investors have seemingly sought solace in perceived “higher-quality” investments despite some arguably elevated valuations. An indication of this can be seen in the relative performance of the MSCI Europe Growth index versus the MSCI Europe Value index, with the former having outperformed the latter by around 2.6 percentage points to the end of July.

European investors have had to come to terms with Italy’s political situation and a closing deadline on Brexit. This has dampened risk appetite in the region as investors contemplated the possible repercussions on the European banking system and any contagion risk associated. The MSCI Europe Financials index is down more than 3 per cent in euro terms to the end of July, the only GICS sector alongside telecoms to post a negative return in the period. 

The best performing sector in Europe has been energy, benefitting from the rise in the oil price since the start of the year. At the stock level, fund managers have reported increased dispersion in company earnings and returns, which should provide opportunities for active managers in the space despite the relatively subdued environment.

Fidelity European Growth holds a Morningstar Analyst Rating of Bronze. The fund is managed by Matt Siddle, who enjoys the support of the very well-resourced analyst team at Fidelity, and in our view he has made good use of this resource. He mainly seeks to invest in quality companies at attractive valuations, but he can also invest tactically in expensive stocks with growth potential and low-quality companies trading at extreme undervaluation.

BGF Continental European Flexible is managed by Alister Hibbert, who has more than 20 years’ investment experience. The manager favours companies with strong franchises, run by quality management, and whose expected earnings potential is underestimated by the market. The approach is unconstrained and can lead to large sector bets, so investors must be able to handle the potential for volatility. However, the long-term performance record is very strong.

Samuel Meakin, CFA – Analyst, Manager Research; Morningstar