It has been a tough 12 months for both US and European equities but while retail investors seem prepared to stick with the world’s largest economy, the same can’t be said for the latter market.
According to the Investment Association (IA), net retail inflows into North America funds in January 2023 totalled £364m, making it the most popular sector that month. Meanwhile, despite outperforming the US during 2022, there were net outflows of £160m for IA Europe ex UK.
Like most of the developed world, sentiment towards investing in Europe was hit by growing inflation and rising rates in 2022, and the MSCI AC Europe Index ended the calendar year down 4.36% in sterling terms. Not only is this ahead of the -9.29% return from the S&P 500 but Europe also remains ahead year to date, with a positive gain of 7.16% versus 2.5%.
As Q1 recedes into the distance, then, should investors be looking to Europe with greater confidence? In this month’s head to head, Fidelity International’s Ian Samson explains why he and his colleagues currently favour a neutral position on Europe, while Hywel Franklin of Mirabaud Asset Management argues that, despite the challenges, there is still room for optimism.
Ian Samson
Multi-asset manager, Fidelity International
Europe’s economy proved stronger than many thought possible last year, due to warmer weather and lower energy prices. Hard data has been more resilient than surveys, leading some to believe a recession could be mild and technical – or avoided altogether. That said, we continue to expect the EU to slip into recession later in the year.
The energy shock is still working its way through the system. Inflation remains stubbornly high and, having already hiked the deposit facility rate to 3%, the European Central Bank (ECB) remains hawkish – signalling there is more tightening to come. And now confidence in the banking sector is wobbling, adding to the uncertainty in the outlook.
We expect the banking sector shock to have a direct impact on banks’ willingness to provide credit, leading to even tighter financing conditions, which in turn would hit the real economy potentially earlier and harder than expected. In this respect, further rate hikes from the ECB would likely lead to overtightening that might ultimately require a rapid course correction in coming months.
Given the global headwinds, we prefer to adopt a defensive bias overall. We are raising the quality of our exposures across the capital structure – for instance preferring higher-quality credit over high yield and lower-beta equities.
Within our equity allocation, we currently favour a neutral position in Europe. Firms and consumers feel more positive about the future than they did a few months ago and China’s reopening has boosted sentiment. European equities look set to face a tougher time ahead, however, especially now that credit conditions are likely to be less favourable.
An eye on the banking sector
In terms of sectors, we are monitoring events in European banking closely. We are mindful markets often overreact on news, which can lead to opportunities, and believe European banks might present just such an opportunity, relative to other cyclical equities, for several reasons.
First, attempts to draw parallels between the US and Swiss banking situations are not convincing. Unlike Silicon Valley and Signature banks, deposit flight does not look to be an issue, and eurozone regulation has prevented significant asset-liability mismatches. Moreover, Credit Suisse had known challenges for some time while eurozone regulators were quick to rule out concerns that debtholders would be disadvantaged in the EU in the way they may have been in Switzerland.
See also: Credit Suisse reveals £55bn haemorrhage before UBS rescue
Second, eurozone banks came into this panic with cheap valuations and return-on-equity at its highest since 2008. In recent weeks, they have only become cheaper and, as we speak, offer a 7% dividend yield.
In particular, EU banks look exceptionally cheap relative to bond yields. Rising bond yields are generally good for banks, because they boost net interest income, and bad for the rest of the markets as they compress valuations. Other cyclical assets do not price in a significant downturn, leaving them more vulnerable from here relative to attractively-valued, beaten-up bank equities.
Third, bank stocks are one of few assets that tend to outperform in a rising yield and falling market environment. Given inflation in the eurozone and US remains a significant concern, this is an attractive property. As such – assuming there are no skeletons in the closet of eurozone banks yet to emerge, and especially if concerns return to ‘higher-for-longer’ interest rates and the fight against inflation – today may prove a fantastic buying opportunity for eurozone banks.
They seem well-insulated from the scares seen in the US and Switzerland, and their return on equity and relative valuations should continue to be attractive if market concerns return to inflation.
Hywel Franklin
Head of European equities, Mirabaud Asset Management
There is no hiding from the fact that Europe was the epicentre of market concerns last year, with a major war on the continent shocking investors with gyrating commodity prices, sharply rising interest rates and almost unimaginable questions about whether countries would need to prioritise heating or production.
Yet things are changing. Recession in Europe – once chalked up as a near-certainty – may now be largely avoided. Gas stores, which many people feared could run dangerously low, are now unusually full. In tandem, the consumer has continued to spend. So perhaps while market optimism has faded, the glass could be half-full.
European expectations face a low hurdle, which is not the case for the US. American exceptionalism has been the rhetoric of the past decade, with economic growth ahead of other regions and a great explosion of innovation driving the economy forward. The tech titans have been among the beneficiaries, seemingly getting more expensive every year. Now, though, many of these companies are starting to show cracks in their growth models. Closer to home, European firms have much lower expectations, with exposure to more traditional industries where growth is more resilient.
Another tailwind for Europe is the China reopening story. Let’s use Germany as an example. It is home to many excellent companies that are active in export markets. China’s zero-Covid policy, coupled with sustained supply-chain disruption, has created an earnings headwind for many of these names. But survey data now points to a gradual improvement in conditions and, as activity normalises, exporters across Europe should see a boost to revenues as factories return to production.
Europe is also a cheap market – so much, so incontrovertible. The prevailing view is this reflects an economy and a stockmarket overexposed to fading industries, sclerotic bureaucracy and a structural lack of dynamism. Yet taking a broad-brush approach ignores the clusters of innovation present across the continent.
Europe has centres of innovation to rival any around the world – they just lack the profile of Silicon Valley. Think about the technology and life sciences clusters around Oxford and Cambridge, or the start-up scene in London. The great advantage for European investors is that many of these highly innovative companies are overlooked, hidden on the junior markets of local EU countries.
‘Safer, smarter, circular’
At Mirabaud, we are focused on uncovering the long-term growth opportunities hidden in plain view. The most exciting themes we see in today’s markets can be summarised as ‘safer’, ‘smarter’ and ‘circular’.
‘Safer’ is all about the increasing need for safety in our personal and professional environments – a trend we see continuing for many years. ‘Smarter’ describes how we need to harness technology to improve quality of life. ‘Circular’ references the way we need to change our living habits to become more efficient and sustainable.
Isle of Man-based Strix is an example of the kind of investment that excites us. As the global leader in kettle controls, you might be forgiven for thinking this is a mature market with limited potential. But the reality is, while the UK market is advanced, the likes of China and the US are much earlier in their adoption of the lowly kitchen kettle.
As an innovator in its field, Strix is expanding into water filters and purifiers, driving change in an industry that has lacked development. Its 2022 headwind is now reversing, as raw material, supply chain and demand disruption all normalise. The stage is set for recovery.
Europe’s future is bright, we feel. It is a cheap market, one that has been overlooked in favour of the US, but which may now enjoy its moment in the limelight. We are focused on companies there with great potential, founded on market shifts that will stand the test of time.
This article first appeared in the April edition of Portfolio Adviser Magazine
