Most investors have been gravitating away from UK and European equities during the past year, put off by the region’s political unknowns and disappointing data.
“Neither look overly attractive when you consider the macro political challenges that reside within each,” says Square Mile investment services director Chris Fleming. “GDP figures have failed to impress, with the UK slipping into negative territory last quarter and most of the core eurozone regions flirting with a recession.”
But frequently the UK is hailed as a ‘bargain’, with world-class companies among UK-based contrarian investors, while Europe is seen as cheap for a reason, ‘challenged’ and ‘vulnerable’.
Uncertain futures
Net redemptions from European equity funds have far surpassed money coming out of UK equities over the past 12 months, with investors yanking £4.4bn from the former compared with the latter’s £3bn, a point that UK commentators have been keen to bring up when talk turns to Britain’s uncertain future in the EU.
Commenting on UK equity funds’ “very high redemptions” of £744m in June, which were 10 times higher than outflows from Europe ex UK funds of £77m, Tilney managing director Jason Hollands notes Europe’s longer 14-month string of negative sales.
“There’s no doubt clouds of anxieties are hanging over both markets,” says Hollands. But while the UK’s woes “can largely be pinned on the ongoing Brexit uncertainties” and the potential for “a very market unfriendly outcome” of a hard Labour administration, Hollands says Europe faces multiple macro and political headwinds on top of Brexit that make it look even less appealing.
Germany, the EU’s economic powerhouse, is teetering on the brink of recession, thanks to a slowdown in manufacturing. A decade of accommodative monetary policy has left yields at ultra-low levels and the banking sector in a fragile state. Also, compared with the UK, Germany is extra vulnerable to global trade uncertainties as it depends more on exports than the consumer and service sector, he says.
Shore Financial Planning director Ben Yearsley agrees that Europe looks more “challenged” than the UK. “Germany has slowed massively; Italy probably shouldn’t be in the eurozone and those are two of the biggest economies.”
The ultra-contrarians place stock in the indomitable British spirit, which won’t be defeated even by Brexit.
“If you look at the history of Britain, when they get backed into a corner, they’re very effective as a people,” says Orbis Investments global equities manager Alec Cutler. “If the British flag-waving bulldog pops out from this, which wouldn’t be an unusual outcome, you can see economic activity just off that.”
Cutler has a third of his portfolio in Europe, which is made up of a 50/50 split of UK and European companies. While others view a potential no-deal Brexit as the worst possible outcome for the UK economy, Cutler sees “complete freedom to blow off any kind of budgetary or fiscal discipline” and envisions the UK could become a kind of “mini US”.
“Even in a hard or no-deal Brexit at least you’ll have certainty and that, plus some patriotism and stimulus, can be a recipe for an economy that improves quite rapidly against the sentiment and an expectation that is super negative.”
Last Word’s in-house research shows more UK-based fund selectors still willing to buy UK equities over European stocks during a politically volatile second quarter.
Down but not out
Though the number of fund buyers planning on upping their exposure to UK equities halved between Q1 and Q2, this was still higher than the number of investors wanting to buy more European equities.
“Europe is always unloved,” says Baillie Gifford European equities manager Moritz Sitte, smiling to himself and shaking his head. Since arriving at the Edinburgh-based manager in 2010 there’s been a torrent of downbeat macroeconomic news coming out of Europe from the debt crisis and now Brexit.
While the £530m European fund Sitte co-manages has been subject to “modest outflows” year to date, according to Baillie Gifford director of marketing and distribution James Budden, flows have been “pretty positive” for the firm’s UK-focused funds.
“We are out-and-out stockpickers and nothing like the index, so I think investors are keen to be discerning in the UK against a Brexit backdrop and ongoing disruption of many industries that dominate the FTSE, such as energy, retail, pharma and financials,” says Budden.
BMO European Equity Select manager Phil Webster says there is still a tendency among UK investors to view allocations to Europe as a box-ticking exercise. His fund has also been subject to some outflows year to date.
“If you look at the portfolio and think, ‘Oh, that looks interesting for what it is’, it doesn’t really matter that it happens to be in Europe – that is where I’m trying to get to,” he explains. “It’s not there yet, because people want to go ‘Here is a European fund, I can put you in a box’. And if they don’t want to allocate any money to Europe, you don’t get any money.”
Investors are more likely to have “a natural home bias” and affinity with their domestic market over others, says Legal & General Investment Management’s head of UK retail sales James Crossley, which could explain why UK investors are more sceptical on Europe’s contrarian potential.
This works both ways, though. European investors have pulled £10bn from UK funds so far this year, while pouring more than €20bn (£18bn) into European funds, sales data from Morningstar show.
European investors were more pessimistic on the UK than global cross-border investors, who only pulled £3.3bn from UK funds during the six months to 31 June 2019. There were net positive flows of £1.3bn from UK investors in homegrown funds.
Bouncing back
Despite investors being more pessimistic on Europe generally, Europe ex UK funds have performed better than their UK counterparts, though Fleming notes this has been helped by the depreciation of sterling against the euro.
Eight out of 10 of the best funds across all IA European and UK equity sectors year to date were European-focused, with Carlos Moreno and Thomas Brown’s Miton European Opportunities topping the table, with a 28% return (see table). Paul Mumford’s smaller companies fund and Nick Train’s £7.4bn UK Equity fund were the only two UK funds to break into the top 10.
This is a notable reversal from one- and three-year performance data, where seven out of 10 of the strongest funds are UK funds.
On a five-year view, the UK also has more winners in the top 10, although the two best performers are Europe-focused funds: Man GLG European and Jupiter European.
Janus Henderson head of UK retail Simon Hillenbrand says he has been “pleasantly surprised” by the bounce-back in European equities this year but thinks it will take more to tempt investors back into the asset class.
“A lot of clients are running with low exposure to European equities generally, and I don’t get the feeling that people are necessarily poised to jump back in,” he tells PA. “What’s the catalyst? Is it just some sort of outcome or is it a hugely positive outcome that people are after? That’s what’s difficult to call at the moment.”
In the meantime, investors have been taking risk off the table, says Hillenbrand, and where they are allocating to equity markets it has largely been via passive funds.
“On one hand, people are not looking to take on lots of risk but on the other, they are aiming to drive returns for their clients, so they do have to do something.”
Cheap stock prices is one of the main contrarian arguments for investing in the UK. Hollands notes that the UK is trading at “a notable discount” to global equities “and that is usually a good starting point for the longer-term investor”.
The FTSE 100 is trading at a price to earnings (P/E) ratio of 14.6x, according to data from Morningstar, while the more domestically focused FTSE 250 is on 17x earnings.
Crossley says wealth managers and advisers he has spoken to believe that most of the Brexit risk has already been priced into UK equities. Many of these buyers will be purchasing large-cap funds that have more international earnings and are therefore less adversely affected by downward swings in the pound, he adds.
But Europe looks cheap, too. Bloomberg data puts the Euro Stoxx 50 P/E ratio at about 17.2x.
Though Webster admits “you can’t completely disconnect” from the macro situation, he deliberately avoids certain types of companies, like the banks in Italy and Spain, industrials, real estate and utilities, which are susceptible in the political climate.
Sitte hunts for Europe’s “hidden champions”. He points out the term, which refers to small but successful enterprises, was coined by German business consultant Hermann Simon to describe bourgeoning businesses on the continent.
His largest position is in a little-known Dutch specialty chemicals distributor called IMCD, whose share price has spiked by 170% during the past five years. Other holdings include the better-known sports brand Adidas, Swedish heat pump maker Nibe and cosmetics company L’Oréal.
When it comes to Europe “a lot of people throw the baby out with the bathwater and ignore the fact that there are fantastic companies. These have long runways to growth, are run by owners with a long-term mindset and have very good alignment of incentives,” says Sitte.
“These companies often have global aspirations and global businesses. The fact that the eurozone is not growing much doesn’t really matter.”
