European equities have been on a strong run over the past 18 months but are broadly considered to be now at or close to fair value. The European Central Bank (ECB) threw a new element into the mix last month, however, by announcing some unprecedented actions aimed at weakening the stubbornly high euro, boosting lending and staving off the threat of deflation across the continent. The measures announced at the 5 June meeting included a cut in the base interest rate to 0.15% from 0.25%, the introduction of a negative deposit rate of -0.1% and new facilities providing cheap loans to banks.
Investors will be asking themselves whether the central bank action provides a legitimate basis to take a fresh look at European equities and, if so, does it improve prospects or is it a reason to worry?
Hopes and fears
According to Rob Burdett, cohead of F&C’s multi-manager team, the measures announced by ECB president Mario Draghi should be cautiously welcomed.
“There is still a fair amount of optimism on Europe, and economic support from the ECB can only help. The question is how much will it help and is it going to be seen as the last resort,” he says.
“You can argue on valuations in individual cases but it’s clear that profit margins are nowhere near peaks and GDP levels are not back to where they were in 2007.”
He believes there is a good chance the “virtuous circle of recovery” will come through into margins more and into GDP as a whole, and that is the big hope for the asset class.
There are reasons to be wary, though. He adds: “Rates can only go so far and the market’s tolerance of quantitative easing-type action is OK at the moment but could have a limit.
“The announcement has been taken positively for now but is being felt more keenly in credit markets than equities, although bonds were trading at some of the lowest rates ever.”
Burdett says investors seeking to profit from the asset class need to exercise a lot of discretion and look closely at valuations and performance.
He believes it remains an appealing territory to invest in, albeit not as attractive as a year ago.
He says: “Our approach was to be neutral or overweight all through last year, and we just went slightly underweight against our peer group about a month ago. This was largely taking profits and also due to being ahead of most peers with our allocation.
“There are some excellent fund managers looking at Europe who will outperform the market and we still think it’s a good area to invest in, particularly as it’s generally one of the easier places to pick funds for.”
Banking on growth
Scott Meech, European equities cohead at UBP, says the market got “everything it hoped for” from the ECB, and more.
“It’s interesting the euro has weakened slightly already, which is a decent benchmark for the success of the measures as the euro’s strength has clearly been a concern,” he says.
He believes the ECB action reiterates to investors in European equities that the bank is on their side and is trying hard to facilitate growth. “The ECB also upped growth targets for 2015 to 1.7% from 1.5%, which shows it is reasonably confident in the effectiveness of the measures.”
If investors do hold the view that on balance European equities are still for them then there is no shortage of good options. However, discerning between the relative merits of different sectors and investment approaches is key in a market where many stocks are already at fair value.
“The key with Europe is that it will be more about the stocks and the managers than the market as a whole,” says Burdett. “Taking most of your risk through the managers works especially well in Europe at the moment.”
Preferred European funds for him are BlackRock European Dynamic, the Henderson European Special Situations fund as well as a combination of pan-European boutique holdings.
He also favours income funds, including options from Standard Life Investments and BlackRock. Burdett’s favoured style for Europe is now tipping towards value. He says: “Our approach in general is to blend styles but we will happily tilt more to certain styles if it’s beneficial. At the moment there is resurgence in the value style, so we are watching that carefully as an option. If you do want to keep playing the recovery then it makes sense to buy more value approach than anything else.”
For Meech, there is earnings upside in European stocks if the recovery does strengthen as forecast. “Investing in the core of Europe in cyclical sectors should be worthwhile on the back of this,” he adds, also echoing Burdett in saying that at this stage in the cycle investing in value is likely to be a better option than growth stocks.
In terms of sectors investors should target to take advantage of the improvement coming as a result of ECB action, Meech points to domestic banks, media and automotive.
“Now that generating capital is easier the domestic banks, particularly in places like Spain, Italy and Greece, should benefit a lot,” he says, adding that he is comfortable with media company valuations.
He also suggests high allocations to autos looks a good bet due to an emerging recovery in European car sales numbers. “The auto companies we’ve been speaking to recently have seemed comfortable with their earnings and margin expectations, so valuations look a bit too low to us and multiples look reasonable,” he says.
“We own BMW and VW as core holdings and we also own Renault as well as Continental.”
UBS Global Asset Management’s European equities manager Max Anderl is more bearish than Meech but still believes there are good ideas out there. “The opportunities are not as great as they were 12-18 months ago and it is quite easy to make Europe as a whole appear unattractive or attractive depending on which side of the coin you look at,” he says.
“It is unattractive if you look at prices versus 12-month earnings and attractive if you look at price divided by 10-year average earnings. Draghi is showing willingness to support the recovery so that’s positive, and the lack of earnings growth is partly due to the strength of the euro so weakening it should help.”
Heavy exporters such as automotives could be the best option for investors, particularly those selling significantly in the US, Anderl adds.
Oriel Asset Management’s Richard Scrope has a similar outlook to Anderl. “With valuations as they are at the moment and the decent run in the past few months, particularly in the peripheries, a lot of stocks look fairly valued now,” he says.“There is still better value to be found than in the US market, though, but it’s really stock-specific.”
Scrope believes investors should look for funds holding companies that can generate large free cash flows, have good earnings visibility and upgrade potential. In his view, sectors that best fit this bill are, again, automotives and also luxury goods.
“Car manufacturers, particularly the German ones, are well placed to generate good cash flows as the domestic car market is coming back and the European makers are growing their share of the market in China,” he says.
“We think there will be value to be found in the European luxury goods segment and growth is still very much there for them, particularly from the Chinese market. These products are selling into the middle classes now as well as the upper classes, and with that being the case valuations do not look particularly stretched.”
Reading the signs
While the overall reaction to the ECB’s measures remains mildly positive and managers do support European equities to some degree, things can change quickly and there are a number of danger signs to watch for when determining how much of a portfolio should be allocated to Europe right now.
Burdett and Meech both emphasise the importance of an up-tick in inflation across Europe within three to six months. Otherwise, a rethink on the merits of the ECB action and the asset class as a whole could be required.
“We should start to see some increase in inflation by the year end. If not, then we’d have to hope for a move to quantitative easing in prompt fashion,” Meech says.
James Sym, manager of the Schroder European Alpha Plus fund, says: “If central banks lose control of the yield curve or we felt there was a strong case that Europe was entering a sustained multi-year deflationary spiral such as Japan suffered in the 1990s, this might cause us to reassess the outlook [for Europe],”
According to Anderl, there are other dangers lurking both to the west and the east, which, while relatively unlikely to materialise, could derail the European recovery despite the ECB’s best efforts.
Any negative economic data out of China, for example, would be a worry given the importance of exports, or a sustained spike in commodity prices resulting from an escalation of conflicts in the Middle East and Ukraine could make things very difficult.