As reported in Portfolio Adviser last week, investors pulled over £700m from UK-listed European equity ETFs in June, the largest outflows seen in any sector. It was a slightly less grim picture for European equity OEICs, with IA figures showing a mid-table June net retail outflow of £28.7m from Europe ex UK funds – a significantly better picture than for any of the UK equity sectors. European equity funds have been among the worst-selling OEICs in 2023 to date, yet they remain the fifth-largest IA sector by AUM. So are UK investors really turning their backs on Europe, and if so, why?
Zehrid Osmani, head of the Global Long-Term Unconstrained (GLTU) team at Martin Currie, points to a worsening view of the European economy, particularly in light of China’s rather lacklustre post-Covid reopening. “Looking at the economic cycle, Europe is both more cyclically sensitive and more cyclically exposed to the China cycle,” he says. “While there was initial excitement around China reopening, it was clear from the second quarter on that the macro picture was weaker than expected, and Europe has had some spillover from that.”
Both Osmani and Georgios Leontaris, CIO Switzerland & EMEA at HSBC Global Private Banking and Wealth, single out particular problems in Germany, the EU’s largest economy. “The macro outlook matters in Europe,” says Leontaris. “Germany is the biggest weight in the index and its GDP growth is stagnating at best. While a recession in Europe is not our base case, the economic growth outlook is so soft that we would not rule out a negative print.”
In its latest World Economic Outlook update (July 2023), the International Monetary Fund forecast GDP growth of just 0.9% for the Euro area in 2023, compared with 1.8% for the US and 3.0% for the world as a whole. Osmani and Leontaris share the view that an improving picture in the US is another headwind for sentiment towards Europe. “While market participants entered 2023 holding their breath on the US, with fears over a recession, bank failures, and debt ceiling negotiations going to the wire, the economic momentum has been stronger despite the aggressive rate rises,” says Osmani.
“On a relative basis, we feel much more comfortable on the US outlook,” adds Leontaris. “We think the Fed rate hiking cycle has run its course, and while we do not think they will rush to cut, a pause can bring a bit of relief and provide some stabilisation. US corporate earnings are also showing more resilience than in Europe, and that is why we maintain a positive stance on the US going forward.”
However, while both managers are more cautious on the outlook for Europe versus the US, Osmani in particular has a substantially overweight position in European equities in his Martin Currie Global Portfolio investment trust (versus the MSCI AC World index), and remains underweight the US, although less so than historically. Close to 40% of the portfolio (adjusted for gearing) is invested in companies in Sweden, Italy, France, the Netherlands and Ireland, compared with 50% (adjusted for gearing) in the US.
A long-term theme in Martin Currie’s GLTU strategies has been luxury goods, a sector in which Europe arguably leads the world. An interesting expression of this theme – given Osmani is generally negative on the automotive sector – is Ferrari. “The automotive space is highly competitive and faces the major challenge of the transition to electric vehicles, which will require a lot of capex. The sector offers an average return on invested capital (ROIC) of 6-8% over the next 10 years, so it is not an appealing area for us,” he says.
“However, Ferrari’s ROIC profile is really super – estimated at 34% next year from 28% this year – as well as having healthy momentum in the top line and profits.” He points to predictability of demand, with long waiting lists and pre-sold limited-edition models able to offset any cyclical sensitivity, as well as strong pricing power, with around 20% of the company’s revenues being driven by added extras such as custom-coloured stitching. “Ferrari sits in the autos space but it is much more in line with long-term luxury goods trends,” Osmani explains. “We see it as a staple – albeit a staple for ultra-high net worth individuals.”
HSBC Global Private Banking and Wealth’s global portfolios, meanwhile, are underweight Europe and overweight the US, yet Leontaris has also had a positive view of consumer brands in Europe, particularly in the luxury space, since late 2022. “A lot of names in Europe are not necessarily selling domestically,” he explains, “so on a bottom-up level we favour quality companies that are less domestically exposed and more geared to the economies on which we have a more positive outlook.”
In spite of a good run of performance from some luxury goods names and the disappointing momentum seen so far in China this year, Leontaris still backs the theme on a long-term basis, although he cautions that at a portfolio level, it is important to blend highly rated sectors with those on lower multiples, as well as avoiding too much pure exposure to China or to companies dependent on a particular driver. “So we like luxury, but it is one theme out of many that we allocate to,” he concludes.
Whatever the rest of this year and next hold for Europe – or indeed the US and China – it seems clear that for the active manager, there are ways to offset a weak macro picture or to benefit from any signs of improvement. This may partly underlie the big discrepancy between (largely passive) ETF outflows and the much smaller outflows from (largely active) European equity OEICs. The increasing trend of allocating to global rather than regional portfolios may also be a factor. On this last point, it is perhaps interesting to note that the IA sector with the biggest net retail outflows in June was not – for once – one of the UK categories, but North America (-£618m).
