European shares took a nosedive at the start of 2016, dragged down by financials stocks. This trend was repeated immediately after the June 2016 Brexit vote. Despite a partial recovery, as of the end of October, the Morningstar Europe Index was still in negative territory for 2016, down 3.7%.
After the surprising outcome of the U.S. presidential election, the next round of political events stretches its shadow over the market outlook for European stocks, starting with the December 4 Italian referendum.
Then we enter an important election year for France and Germany, while the United Kingdom is expected to begin negotiations to leave the European Union.
How Our Top Rated Funds Fared
Against this backdrop, 2016 has been a challenging year for active managers in European equities, and many Morningstar top rated, or “medalist” funds have struggled to match their respective indexes or category peers in the near term. This is in stark contrast to 2015, when most of these funds were ahead of their respective peers and indexes.
Of the 36 funds in the Europe large-cap equity Morningstar Categories that carried positive Morningstar Analyst Ratings, six outperformed their respective category indexes in the year-to-date period ended October 31, 2016, and 10 outperformed the average peer.
This is a change from 2015, when 30 medalists exceeded their respective indexes and 26 beat their average peer. While medalist funds in the Europe equity large-cap growth category continued to do reasonably well on a relative basis, medalists in the large-cap blend and large-cap value categories had a harder time compared with both peers and the broader market.
In the Europe ex-UK large-cap equity category, eight out of 24 medalist funds outperformed the MSCI Europe ex UK Index and the average peer in 2016. By contrast, in 2015, 23 of these outperformed the index, and 14 beat the category average. Among our16 medalists in the eurozone large-cap equity category, only two exceeded the returns of the average peer and the MSCI EMU Index, while in 2015 nearly all were ahead of their index and average peer.
What Drove Performance?
Overall, there have been sharp gyrations across sectors, styles, and countries. For instance, quality companies with visible growth prospects were favoured by market participants in the first half of the year but lost ground in the ensuing months. Choosing stocks with above-average growth metrics, high multiples, and wide Morningstar Economic Moat Ratings – companies that Morningstar equity analysts believe display strong and durable competitive advantages – would have been a winning strategy for the first two quarters, but value and no-moat stocks outperformed in the third quarter and in October.
Investors have also given a second look at beaten-down companies in the energy and commodity related sectors after months of dismal returns. But country – or currency-specific issues, such as those faced by UK and Italy, and sector-specific anxieties in financials and healthcare exerted strong downside pressures on the market.
Healthcare stocks were among the worst performers up to October 2016, but at the time of this writing, the US election outcome seems to have changed their outlook.
Energy & Materials Stocks Rally, Financials Feel the Pain
The average fund in the Europe large-cap equity categories was underweight both the basic-materials and energy sectors relative to its respective category benchmark, but there were exceptions. Silver-rated Schroder European had a 19% allocation to basic materials, which was more than twice the category average and benchmark weight.
The fund was mainly exposed to chemical names, therefore not capturing the recovery in the metals and mining space. However, the strong performance of holdings such as Sika and Koninklijke DSM helped the fund to exceed its benchmark for the year to date. Within the industrial sector, conglomerates and electrical equipment companies led the way.
All financials subsectors had a tough year. Being underweight financials – banking stocks in particular – was somewhat of a consensus trade that most active managers benefited from. There were several Morningstar Medalists with a zero weighting in the financials sector, including Gold-rated fund Comgest Growth Europe.
SLI European Equity Income managed to outperform both its category index and average peer through October 2016 despite having a fairly high exposure to financials.
A majority of funds in the Europe large-cap equity categories were overweight the underperforming healthcare sector, including larger negative contributors such as Bayer, Novartis, and Novo Nordisk. Jupiter European was tripped up by its allocation to healthcare, which at times exceeded 30% of the portfolio.
