Where next for markets as Europe moves from recovery to expansion?
The 2018 Schroders Investment Conference took place against a backdrop of strong economic data from Europe, but also a week of significant stockmarket volatility.
Our investment experts Johanna Kyrklund, Global Head of Multi-Asset Investment, Martin Skanberg, Fund Manager, European Equities and James Sym, Fund Manager, European Equities discussed the economic outlook for Europe, monetary policy and the prospects for equities.
Audience upbeat on equities
The session started with three questions to the audience. Firstly, what is the biggest risk factor for European markets in 2018? The audience selected “Potential tightening of monetary policy (in the EU or elsewhere)” by a wide margin. Political risks and the euro were much lesser concerns.
Source: Schroders Investment Conference, February 2018.
Question two asked the audience their preferred asset class for 2018, out of a choice of European equities, European credit, Global multi-asset, or None of the above. European equities was the clear favourite with 58% of the vote.
The audience’s bullishness was in further evidence in the answer to question three, on the recent stockmarket volatility. Over 50% saw it as “an opportunity to buy on the dips”, while many others deemed it “noise to be ignored” and only a small proportion thought it was “the start of a long-term downturn”.
Supportive economic backdrop
The panel began by considering the broad outlook for Europe. Economic growth has improved and forward-looking indicators remain positive, begging the question of whether the economic situation is as rosy as it seems, and for how long can it continue.
“The economic environment is still benign with the European recovery continuing to come through. That said, the sovereign debt crisis in Europe is dormant but not over. Bond spreads have been suppressed by the authorities, via monetary policy, and will snap back at some point. In many ways, this better economic environment has made the challenge for the authorities more difficult.”
“The economic expansion we’re seeing in Europe can continue. The key reason why is that corporate management teams are now incentivised to invest and this is the leg of the recovery that has been missing. Capital expenditure can help prolong the current expansion.”
“More investment is certainly good for revenues but there is the prospect that costs will go up and this could squeeze profit margins. There is always an initial benefit from higher inflation, but as rates rise to contain this then that can trigger the next downturn. That is how cycles work.
“Another aspect to consider though is the structural reforms that have taken place in Europe over the past few years. Talking to companies, there are many - in Spain for example - who are very positive about the reforms that have been made. Europe is a big net exporter, largely due to Germany. But the internal consumption element is something that hasn’t yet come through and this could be the next element driving economic growth.”
Are European equities expensive?
The panel then moved on to discuss asset valuations, particularly equities given the gains seen over the past year.
“Valuations have improved; we are ten years into an equity bull run. But Europe is about four years behind the US cycle, which is not a bad place to be right now. Cyclically-adjusted price-to-earnings ratios are still below their long-term trend in Europe so there is a gap to close. Eurozone equities still look attractive, or even cheap, compared to other regions. Corporate profit margins in Europe are still some 30% below their 2006 peak so there is still room for improvement.”
“Relative to very expensive government bonds, equity valuations look reasonable. But one issue is that government bonds are finally starting to re-price. If this continues it could make equity market valuations look a little more stretched. In many ways though, one could view this as a good thing as it means the cycle is intact and we are not entering a Japan-style slump.
“There are three key considerations we would have for the coming year: 1) don’t get too greedy; 2) be diversified; and c) plan for a more difficult environment in the next two or three years.”
“Valuations in aggregate look fine. However, after years of zero interest rate policy and quantitative easing, dispersion between stocks and sectors is enormous as some have benefited from ultra-low rates and some have not. Low or zero interest rates have allowed certain companies to grow and gain market share while making very low – or no – profits. That is a hugely deflationary force.
“However, as investors, high inflation means that we may start to require, for example, a 5% dividend yield to compensate for taking equity market risk. Companies that currently make little profit may find they need to raise their prices in order to pay that dividend. That could imperil their ability to grow, and call their current high valuations into question.
“We avoid these kinds of growth stocks, often found in the technology sector. By contrast, some ‘old-fashioned’ UK general retail stocks look very cheap.”
How will QE withdrawal affect European markets?
As the first question to the audience had demonstrated, tighter monetary policy this year is a key concern for investors, with particular consequences for fixed income assets.
“We’re not expecting the European Central Bank (ECB) to make a very aggressive change to policy; we think they will move quite slowly. Keeping control of the BTP (Italian government bond) spread is essential for ECB chairman Mario Draghi.
“A return to positive rates will hurt growth stocks. This is what I mean by ‘don’t get greedy’. Those stocks have done well, but now is not the time to chase that performance.
“In our view, German Bunds have exercised something of a gravitational pull on other bonds, especially US yields. Removing the anchor from Bunds could re-set rates globally”.
Is there a risk of currency wars?
The discussion then moved on to global trade and currencies. Fears of US protectionism have so far been unfounded but the relative weakness of the US dollar has raised some concerns over the outlook for European exporters, particularly if growth elsewhere in the world were to slow.
“We have had years of low growth where whoever had the weakest currency stole the biggest share of the pie. With the synchronised global recovery, that’s not the case anymore. We see no reason why the ECB should try to talk down the strength of the euro. Currencies generally are being allowed to move with fundamentals. Rates are a big issue but currencies are not, in my view.”
“On the demand side, there is the prospect that internal consumption could pick up the slack from any slowdown elsewhere. The rest of the world has long been asking Germany to consume more.”
“Part of this comes down to Germany’s uber-competitiveness. On average, Europe makes productivity gains of around 3% per year. In France, for example, this tends to be swallowed up by wage increases. That hasn’t been the case in Germany. However, German employers are now facing greater wage pressures; for example, the IG Metall union asked for a 6% increase and a 28-hour week. Germany needs to harvest its productivity gains and ensure these ‘trickle down’ to workers.”
Best investment ideas
To conclude, the panel named their preferred sectors or asset classes for the next one to three years.
“The materials sector, for example, chemicals or paper & packing, is one with a lot of opportunities. Rising input costs are good for the sector and it offers cheap, consumer exposure. What is more, Chinese producers are facing rising costs, as environmental considerations take on greater importance. European materials companies are well-positioned in terms of both cost and innovation.”
“Emerging markets, particularly equities, would be my pick. Valuations look better supported and there is less political risk now in emerging markets than in developed ones.”
“The current low rate environment is unsustainable. Consumers, or ‘Main Street’ have suffered too much and interest rates need to go up to help deflate assets such as house prices. I would therefore look at consumer value stocks. I’d also favour some cash, in the expectation that any change of environment brings about new opportunities into which we can deploy capital.”
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