Europe began 2018 as one of the favoured regions for many asset allocators. However, sentiment to continental equities continues to wane as we enter the second half of the year.
Last year saw European companies’ earnings beat start-of-year estimates for the first time since 2013 and earnings almost reached double digits in 2017. While GDP growth is expected to moderate going forward, it still runs at a decent pace.
But supposed political turmoil in the likes of Italy, Germany and Spain have weighed on markets and re-ignited fears over the future of both the European Union and the euro. Indeed, it is feared that Italy’s newly elected Government will attempt to take its country out of the single currency bloc.
Trade rhetoric between the US and China has not helped, with the EU caught in the middle. The potential for tariffs to be slapped on cars is the main point of concern for Europe. Broker UBS has predicted the Stoxx 600 index could fall by as much as 25% in a worst-case scenario.
The argument for Europe back in December and January was relative value compared to the US. But now with US powering ahead with tax reforms benefiting corporates, it seems barely any investors want to know European stocks anymore.
We have already revealed the extent to which investors dumped European equity-focused ETFs year-to-date, with almost €9 billion withdrawn in the second quarter.
A similar trend happened with open-end funds. The Investment Association Europe ex-UK sector saw £710 million of inflows in the first quarter of 2018, but that was followed in Q2 by redemptions totalling £850 million. In fact, June’s near-£500 million withdrawal was the worst the sector has seen since August 2016.
But the fundamentals haven’t really changed. Corporate profits are still growing strongly in Europe and, while it’s true that parts of the continent look troubled, economic growth is, too.
Of course, Europe’s economic recovery still lags America’s, due to the eurozone crisis hitting shortly after the financial crisis ended.
The US and European stock markets, too, were highly correlated until around 2012. Since both the MSCI Europe ex UK and Russell 1000 indices bottomed in early 2009, though, the latter has doubled the returns of the former.
However, earnings growth of 9.1% in 2017 should be followed by similar numbers this year and next. “In other words, 30-odd-percent earnings growth out of Europe in three years – that’s a fundamental change,” says Olly Russ, manager of the Liontrust European Income fund.
“So, it is making up for a bit of lost time. The economic growth in Europe is really driving it. Even Greece is returning to growth; Eastern Europe is growing very strongly, as are the Nordics and Spain. It’s kind of firing on all cylinders at the moment.”
France Leads the Pack
Russ is particularly bullish on France due to President Macron’s reforms, while he notes that Italy isn’t fiscally as profligate as you might expect. He also believes its threats to leave the euro are simply a negotiating ploy to get some concessions out of the EU on budgets.
European fund managers are still finding opportunities, though. Markets throughout the continent continue to trade well below their US counterparts. The 10-year chart of leading benchmark indices of Europe’s largest markets shows Germany and Switzerland surging ahead at 99% and 91% respectively.
Spain is up just 20%, but recent events have taken Italy back into negative territory, losing 1.19% in that time. Despite that, Russ has plenty of ideas. “It’s very cheap at the moment. You might say cheap for a reason, but let’s face it, if it crashes out of the euro everything’s going to go down,” he says.
“I think it’s all a bit overdone, really. Italy’s pretty much as cheap as it has been since the last crisis, which was the 2016 constitutional referendum.”
But Russ thinks it has some “fundamentally good companies on bargain prices”. One of his “all-time favourites” is Terna (TRN), the Italian national grid, whose share price has almost doubled over the past decade.
The stock, which has been in the portfolio since inception, is “incredibly dull”. “All they do is run the grid and then return every spare cent to shareholders. It’s on more or less the same yield I bought it on 10 years ago. It’s done very well, despite being both Italian and a utility, neither of which have been overly helpful over the last few years.”
Automotive Sector
Another area that it has not been helpful to be in during the more recent past is the automotive sector, with potential tariffs on the horizon. And Europe has plenty of listed car makers.
But it’s an area Rob Burnett, manager of the Neptune European Opportunities fund, likes. He owns Daimler (DAI), Renault (RNO) and Volkswagen (VOW3), and tyre maker Continental. These all contributed to a 6% first-half underperformance in his fund. His response to this was not to reduce his exposure, but “marginally increase it”.
Despite Trump’s bluster about tariffs for car makers, “what he really wants is for tariffs to be abolished”, claims Burnett. The reason for this is that the tariffs for US cars going into Europe are currently four times higher than for European cars going into the US.
The European car makers want the same thing, so “it’s important for investors to appreciate that we could have a tariff announcement in relation to autos that’s a positive one where they go down”.
Of course, that’s not the only structural challenge facing the sector. The move away from diesel cars to electric ones has begun in earnest, though of course this is a risk the car makers themselves can control.
On more structural shift is a perception of peak demand for cars having been reached. Younger people now cannot afford new cars, so are turning either to used vehicles or shunning them altogether to use ride-hailing apps like Uber.
However, while demand for new cars is clearly at all-time lows with millennials, it is still high with over 50s. This is where car makers revenues and profits will come from in the future. A further win here is that younger consumers tend to buy low-margin compact cars, whereas the older generation plump for higher-margin luxury cars.
The importance of this fact is linked to demographics. In developed markets, where these trends are playing out, the cohort that is growing the fastest is over 50s.
With the sector trading at record low valuations over all metrics, Burnett says he has “very high conviction on the upside for this sector over the next six to 12 months”. Volkswagen is his “top pick”.
Financial Valuations Offer Opportunities
Both Russ and Burnett are fans of financials in Europe, but their focus is on different areas of the sector.
Burnett says banks, like autos, have seen earnings per share figures stabilise in recent years, but valuations are hugely depressed. But earnings and net interest margins are both now close to a trough, which means it will be easier for banks to increase their earnings.
This has created “a ludicrous degree of valuation support” and he sees a “stand-out opportunity” in banks.
Russ prefers insurers, particularly re-insurers. He says that Europe has some of the largest players in this market – the likes of Munich Re, Swiss Re, Allianz (ALV), Zurich (ZURN) and AXA (AXA).
“These are global names that have continued to pay cash dividends, most of them through the crisis, actually,” he says. “They didn’t have the big equity raises that the banks did and they very swiftly came back with cash payments and they weren’t regulated to death by the regulators.”
