Whisper it quietly but things could finally be looking up for Europe. After 18 tortuous months the eurozone appears to have dragged itself out of recession with GDP having risen 0.3% during the second quarter of 2013, according to Eurostat.
Germany and France both posted better-than expected growth of 0.7% and 0.5% respectively, but among the most impressive performers was Portugal, which defied its reputation as one of the weaker economies by growing 1.1%.
It’s still early days as far as a recovery is concerned and plenty of issues remain, but Julian Chillingworth (pictured left), chief investment officer of Rathbones, believes the latest figures are indicative of a better environment starting to emerge.
‘The last few years have been very difficult for European economies but it now looks as if the economic trends are improving,’ he says. ‘The US is also expected to post reasonable growth so demand for European goods and services should also increase.’
This in turn is likely to encourage more interest in the region. ‘If people are feeling more confident they will be happy to invest their money,’ he says.
This sense of optimism is reinforced by the BofA Merrill Lynch Fund Manager Survey for August, which reports 88% of European fund managers believe the region will strengthen over the coming year – twice as many as in the previous month.
The study found respondents increasingly viewed stronger growth as the likeliest solution to the eurozone debt crisis, rather than interventions by the European Central Bank, while the introduction of a European banking union would further improve sentiment.
As a result of the more positive macroeconomic landscape, investors have been positioning for gains in the region’s equities. In fact, 20% of respondents would overweight the market on a 12-month view.
Deep-rooted problems persist
Ted Scott, director of global strategy at F&C Investments acknowledges the pick-up in economic news but questions the positive response by some commentators who have declared that the debt crisis will soon be consigned to the history books.
‘Such a conclusion is simplistic because the debt problems reflect much more than a lack of economic growth in a currency union comprising 17 contrasting countries with different languages, cultures, political systems and labour practices,’ he says. ‘The deeper recession in Europe following the financial crisis is a symptom of the debt crisis and, due to the policy mistakes by the Troika it is still a long way from resolution.’
Looking ahead the status quo is likely to continue, he believes, with the Troika and the ECB providing the necessary crisis support to prevent contagion and keep bond yields suppressed.
‘It is not a solution, however, and the divergent nature of the currency union will mean that growth remains elusive without the necessary fundamental reforms,’ he says. ‘This requires significant strides towards a fiscal and political union as well as a common currency and major structural reforms in the peripheral countries to remove the obstacles to growth. Such a transformation, if it does happen, is likely to take many years and without it the outlook for growth remains subdued.’
Adrian Darley, head of European equities at Ignis Asset Management, predicts a ‘black zero’ in terms of European real GDP over the next 12 months, which he defines as being just slightly above zero.
‘Switzerland, Germany and the Nordic countries will be at the stronger end of things and Italy, Spain, France and the Netherlands at the weaker,’ he says. ‘This sluggish macro backdrop will ensure interest rates stay at very low levels. It’s not possible to imagine the ECB embarking on further non-standard measures to try and reinvigorate economic activity.’
Given this backdrop, Darley suggests European corporates will continue to focus on cost and cap-ex control, so free cash flows should be healthy. A robust North American economy is expected to support exports while emerging market currency volatility will remain a headwind for European exporters.
‘Stock selection will remain important but macro volatility will also throw up opportunities to reduce positions into over exuberance and add to positions during periods of pessimism,’ he says. ‘The key message is that there are many globally dominant European companies that will prosper in both good and bad times and these are generally the ones investors should continue to focus on.’
Investor opinion split
The importance of the economic outlook clearly divides fund manager opinion. Many insist it’s nothing more than a sideshow and point to the fact that a number of the region’s largest listed companies generate their profits elsewhere and aren’t reliant on their home market.
Others place a lot more emphasis on the data, arguing that it’s important from a confidence perspective. For example, Citywire AAA-rated John Surplice, who manages a number of pan European equity funds for Invesco Perpetual, believes the improving economic backdrop in Europe is relevant. ‘If growth in Europe comes back even to a small extent – even 1% – it’s going to feel a much better environment than some of these emerging markets where growth is slowing from a high level.’
Surplice believes that if you invest in markets when there’s a lot of fear and when valuations on a cyclically adjusted basis are low, there’s a greater chance of getting good returns over the coming 10 years. ‘People shun investing when they’re fearful even if valuations are low, but that’s exactly the time you want to be investing,’ he says.
The last few years have certainly been challenging in that respect. ‘Since the debt crisis came Europe has felt pretty toxic at times but if I look back over five years our pan European fund has outperformed the market pretty consistently,’ he says. ‘That indicates it’s been possible to generate a considerable amount of alpha – and that you haven’t had to really increase volatility. When there’s so much fear in the market it creates opportunities for active managers, as long as they maintain their discipline, properly analyse the risks out there, draw their own conclusions and back their judgment.’
This is particularly relevant when the market is not in your favour. Surplice cites the example of having gone overweight financials in the second quarter of 2011. ‘For a lot of time since then, owning a continental European bank has been terrible,’ he admits. ‘It’s only in the last 12 months that this strategy has really come to fruition. In the period beforehand there was a lot of navel gazing so it’s important to make sure you’re still happy that the positioning is correct because you’re not getting any comfort from the markets.’
AAA-rated Matt Siddle (pictured left), who manages funds such as Fidelity European Growth, believes the financial stress in Europe has been tempered since European Central Bank President Mario Draghi’s vow last year to do ‘whatever it takes’ to prevent a eurozone break-up. This pledge, along with the OMT policy, has helped boost investor optimism and support equity market gains, he says.
‘Europe continues to face challenges in competitiveness and government debt-to-GDP levels remain high while the amount of bad debts on bank balance sheets in countries such as Spain and Italy still need to be tackled,’ he says. ‘However, a rebalancing is under way and peripheral nation current accounts have improved.’
Siddle argues that better recent economic data, combined with talk of tapering in the US, means that longer-term interest rates have started to rise from multi-decade lows in markets such as Germany, and put pressure on long-term bond prices.
‘This sets the scene for investors to rotate into good quality equities with dividend yields that are higher than bond yields. These are companies are exposed to the improving economic prospects and can deliver attractive long-term returns,’ he says.
Time to fix structural issues
Many companies have successfully shaken up their own business models – and now is the time for structural issues within certain countries to be addressed, says Nicolas Walewski, manager of the Alken Return Absolute Europe fund.
‘We are seeing an improvement in underlying company profitability and productivity,’ he says. ‘However, structural government reforms in France and Italy are long overdue and are needed to address the structural low productivity in those countries,’ he says.
Walewski, who argues that companies willing to invest in their futures will be in an advantageous position, expects oligopolies, innovators, low-cost business models and restructuring stories will prosper in Europe over the next few years.
‘Oligopolies dominate markets and protect margins by controlling pricing power,’ he says. ‘Around 60% of our fund is invested in these markets with our two largest holdings, Seagate and Western Digital, being two good examples.’
Innovators, he adds, have the ability to create their own markets and market share, driving both volume growth and pricing power. ‘We often find these in the technology space which is a very diverse and uncorrelated sector,’ he says. ‘Companies such as Temenos and Grifols create an edge over their competitors and high barriers to entry.’
Low-cost business models such as Ryanair, meanwhile, are able to capture market share gains through competitive pricing structures, continues Walewski, who believes there are also some very interesting restructuring tales around such as Carrefour.
‘The company was mismanaged for more than a decade, but the new CEO seems determined to bring the company back to creating value and there is room for significant margin improvement,’ he says.
The key fact is that many European companies offer the tantalizing combination of strong global market positions and valuations that are still cheap relative to a variety of metrics, including historic valuations, says Fidelity’s Siddle. ‘Combine this with signs of improvement in the local European economy and you have an attractive opportunity to deliver strong long-term returns for investors,’ he says.
This would be ideal but even if European economies fail to maintain momentum there will still be plenty of exciting investment opportunities in companies with truly international brands, according to AAA-rated Arnaud Cosserat of the Comgest Growth Europe fund.
‘Despite the tough environment you will find companies that defy the gravity of the European economy because they have unique business models, good levels of transparency and accounting, and are reasonably valued,’ he says.
Surplice of Invesco agrees. ‘Even though we’ve had a couple of good years in Europe we should be mindful that earnings are still 40% below where they were in 2007, whereas the US is 20% higher,’ he points out. ‘Therefore, if you believe in a stabilising western economy where there will be more earnings upsides for European companies than for US companies, then I think we can have a few more good years.’
This article originally appeared in the September issue of Citywire Global magazine