EuroView: Quarterly Market Insight - Q3 2015

Markets in a tailspin

After the Greek debt negotiations in the second quarter, we highlighted that the main risks on the horizon included US rates and the Chinese economy.

These two issues have indeed dominated the headlines over the summer, sending markets into a tailspin.

The MSCI Europe index lost 8.9% in the third quarter leaving year-to-date returns at +2.8%. When compared to other global markets, Europe has done well so far this year.

The S&P 500 is down -5.3% and emerging markets overall are down -15.6%, although for international investors euro depreciation makes European and US returns comparable on a like-for-like currency basis.

Of course, the US market continues to be the stand-out performer since the depths of the 2008 financial crisis having outperformed Europe by over 40%.

Market volatility has picked up markedly since August when the Chinese made a number of significant policy changes including devaluing the yuan along with some serious stockmarket interventions.

Chicago Board Options Exchange Volatility Index

Source: Thomson Datastream, as at 30 September 2015.

Global investors interpreted these moves as reflecting further weakness in the Chinese economy and misguided policy adjustments on the part of the authorities.

The knock-on effect of a China hard landing on the rest of the global economy is very difficult to quantify but the impact of declining commodity prices on emerging market economies more generally is significant and has been going on for some time.

China forces Fed hand

The uncertainty around China has forced the deferral of a rate increase from the Federal Reserve (Fed).

The recovery in the US economy would suggest to us that Fed Chair Janet Yellen should follow through on her commitment to raise rates this year.

However, in the eyes of the Fed, a rate rise in September was deemed too dangerous for market sentiment given the unpredictability of the Chinese economy.

Alternatively, the Fed may have felt that the strength of the US dollar had already tightened monetary policy and as there is no sign of inflation, saw no reason to raise interest rates at this point.

Whatever their true thinking, subsequent market volatility implies investors have taken the view that the Fed is very concerned about the sustainability of global growth and the risk of deflation.

Europe provides safe haven

As we have stated previously, whilst China has been a significant growth market for European companies, the absolute exposure for European exporters overall is relatively small.

In addition, our portfolio focus has been on companies that were either beneficiaries of the intra-European recovery or alternatively ‘safe-haven’ companies with little or no exposure to the emerging market slowdown.

We retain this overall view but it is critical that we constantly challenge our investment theses. With this in mind, we will use the rest of this review to explore further many of the issues discussed so far.

Europe's exposure to China

As European equity investors, how concerned should we be about a Chinese economic slowdown? The answer is that we should probably be concerned, but not to the degree the headline writers would have us believe.

Companies are very reluctant to provide a breakdown of their sales or profits at the country level, primarily for competitive reasons.

We know that roughly one third of sales within the MSCI European universe of companies go to emerging markets, but beyond that there is very little detail.

At the EU level in 2014, goods exported from the EU amounted to approximately €1.7 trillion, of which only €165 billion, or less than 10%, went to China.

This compares with around €2.8 trillion of goods traded within the EU.

Many are doubting the sustainability of the recovery in Europe, particularly given events in China.

To put this in perspective, the value of Chinese exports from the EU are slightly more than goods exported to Switzerland, or around half those to the US.

Of course, the average Chinese export growth rate of 9.8% per annum between 2010–14 has helped the struggling European economy, particularly during the eurozone crisis.

Looking forward, however, we believe the domestic consumption story is a more significant driver of the economy than exports, and we touch on this in more detail later.

We should also be cognisant of the mix of industries that are susceptible to a slowdown in exports; for example 70% of EU goods exported to China fall within the industrials sectors, namely machinery, transport equipment, chemicals and related products.

Consequently, a bias towards businesses that benefit from the pick up in intra-European trade should be beneficial for portfolios.

European recovery?

The European Central Bank (ECB) provided a significant boost to the eurozone economy in January through the quantitative easing (QE) programme.

Prior to the summer, asset prices, including equity markets, benefited from the increased liquidity and the weaker euro.

Recently though, Mario Draghi has warned that global forces are likely to negatively impact GDP growth and commodity price declines will prevent the ECB achieving the 2% inflation target anytime soon.

In addition, he has already alluded to a probable extension of quantitative easing beyond the original September 2016 end-date.

Of critical importance to Draghi is the euro, which has been trading in the 1.1–1.15 range versus the dollar for the last five months.

Euro/Dollar exchange rate

Source: Thomson Datastream, as at 30 September 2015.

Quantitative easing will help keep the euro under pressure especially if the Fed does decide to raise rates.

We’ve seen a near 20% fall in the euro versus the dollar since mid-2014, which has helped corporate earnings growth; estimates suggest a 10% decline in EUR/USD translates into approximately 5% earnings growth.

The decline in the oil price has of course also provided an implicit tax cut for consumers.

Despite these tailwinds, many are doubting the sustainability of the recovery in Europe, particularly given the China events discussed previously.

We would take a more optimistic view based on the consumer confidence and retail sales data ...

Euro area consumer confidence and retail sales

Source: Thomson Datastream, as at 30 September 2015.

... as well as the purchasing managers’ index (PMI) surveys and loan demand, particularly given continued monetary easing.

Eurozone PMI surveys and credit expansion

1Source: Thomson Datastream, Markit Economics, 15 September 2015.
2Source: Thomson Datastream, as at 30 September 2015.

During the quarter just gone, the international cyclical sectors were the hardest hit with the German market in particular suffering on account of their export bias.

The more defensive sectors continue to perform well such as consumer staples and healthcare.

Correlations in markets overall have increased as the macro uncertainties have dominated sentiment recently.

Rising stock correlation in Europe

Source: Schroders, Bloomberg, as at 29 September 2015.

In particular, companies with commodity exposure have performed almost uniformly badly while defensive stocks with annuity-like characteristics have likewise nearly all performed well.

We very much see greater correlations in markets as an opportunity given our focus on bottom-up stockpicking where we can identify greater differentiation between companies than is currently being factored into share prices.

From an international trade perspective, we know Europe has a far more open economy than the US with international EU exports as a percentage of GDP more that 3 times that of the US.

Concern therefore is building around European corporate earnings and it is perhaps not surprising that confidence is fragile, all the more so given the Volkswagen scandal. (link)

Whilst the most recent one month earnings revisions chart has turned sharply negative at the global and European level, we see this as a somewhat specific commodity- and autos-related downgrade.

European earnings revisions

Source: BofA Merrill Lynch Global Quantitative Strategy, September 2015.

The longer-term outlook and the real impact of QE is a much larger topic.

The world’s stubbornly high debt levels, deflationary forces, structural reforms and lack of fiscal cohesion all point to a fairly uncertain environment. Some of these structural issues will take many years to resolve.

Greece’s problems are not over and the popularity of nationalist parties in many countries could well increase with the current refugee crisis.

Our view is that whilst Europe has its problems, the reality is that, despite Volkswagen, the EU is home to some of the best companies and those should command a premium in an uncertain world.

The cyclically adjusted price-earnings chart illustrated shows that long-term European valuations overall remain at a discount to the US and many companies will benefit from utilising excess capacity as the economy grows, albeit slowly.

Cyclically adjusted price to earnings ratio

Source: Thomson Datastream, Schroders, 30 September 2015.

What are the US risks?

Never has there been so much deliberation over a shift in rates by the Fed.

The irony is that given interest rates are close to zero, it’s difficult to see what impact a 25 basis point increase will have on the underlying economy.

The move has become almost entirely symbolic, with the market now paranoid about what a move or non-move might mean for the global economy, let alone for the US itself.

The Fed’s predictive ability during the global financial crisis would suggest it is not much better than anyone else in anticipating global trends.

Over the last 25 years, the first interest rate hike has been greeted with an average 7% fall in the S&P500.

However, over the following six months, the market has rallied back above the starting point as the focus has shifted towards the strength of the underlying economy, the improved outlook for corporate earnings and so on.

This has happened three times since 1990, but this time things are different.

The market has already declined in anticipation, the dollar has strengthened and we are already well into the corporate earnings cycle where margins are at historic peaks.

The following two charts compare forward earnings per share and historic margins for Europe and the US.

Trailing 12-month net profit margin (%)

Source: Bloomberg, 31 August 2015.

Forward earnings-per-share

Source: Thomson Datastream, 30 September 2015.

Headline unemployment has come down to levels that would indicate rates should go up.

The problem is that there is no sign of inflation, which is usually the result of tightening labour markets and greater utilisation of spare capacity in the economy.

Once again we have to look to China, where increased global deflationary forces are being created.

Commodity prices buoyed by infrastructure expansion in China over the last decade are normalising and excess capacity built in China during its boom period is producing goods that now flood global markets, thus lowering prices.

US unemployment and inflation

Source: Thomson Datastream, August 2015.

The Fed’s reluctance to raise rates is understandable, especially given the pressure on corporate earnings revisions which through a combination of dollar strength, imported deflation and tightening labour markets, have lurched downwards.

The problem for us is that it doesn’t seem healthy to have market sentiment so obsessively attached to mutterings about rates around the Fed meeting schedule.

The Fed’s predictive ability during the global financial crisis would suggest it is not much better than anyone else in anticipating global trends.

Governance and sustainability

Another major factor impacting sentiment during the third quarter was the Volkswagen scandal which is off the Richter scale in terms of corporate governance abuse.

We pride ourselves on investing in sustainable business models and we believe companies that embrace and actively promote strong corporate governance will flourish in the future.

The warning signs with Volkswagen have been there for many years given the ownership and boardroom structure, but the magnitude of this debacle surprised us.

The reverberations around the autos sector and the market more broadly have been significant and there’s no doubt confidence has been shaken.

We allocate capital on behalf of our clients and we do so having carried out thorough, independent analysis on all aspects of our companies.

Whilst hidden practices are virtually impossible to detect from the outside, our industry has to improve in pressurising European companies to adopt better governance practices.

There were many tell-tale signs at Volkswagen, such as a totally ineffective whistleblowing policy and the low level of board independence.

With only one board member out of 20 considered independent, there cannot be a culture of challenge and, whilst we welcome the announced management change, it feels cosmetic rather than transformational.

The controlling shareholders, the Piëchs and the Porsches, are aligned with shareholders in terms of generating shareholder value, but the lack of independence has undoubtedly been a contributor to poor risk management and oversight.

The company has been managed as a private, family-run company with little evidence of board effectiveness.

This apparent sloppiness and arrogance is reflected in the time taken for the company to respond to the initial claims of faulty software (the so-called ‘defeat device’) coming from the US investigative body, the International Council on Clean Transportation (ICCT), as early as 2014.

Whilst hidden practices are virtually impossible to detect from the outside, our industry has to improve in pressurising European companies to adopt better governance practices.

The sustainability of their businesses depends on it and we at Schroders are an increasingly loud voice in this regard.

UK-specific factors

The UK market fell almost 6% in the third quarter as victims of potentially slower global growth led the market lower.

The worst-performing sectors were mining (-32%) and oil and gas (-10%) where the China association is obvious.

The small- and mid-cap, more domestically-focused area of the market fared better (small-cap -2%, mid-cap -4%) as the prospect of UK interest rate increases has receded in the short term.

Earnings risk has also been a feature, particularly for those companies with stretched balance sheets.

The extreme example is Glencore, where the company is completely at the mercy of the copper price. However, more defensive companies such as Tesco and AA have also been under pressure.

For related content:

Chinese government government stimulus to boost sentiment but not growth

March 2016 eyed as Fed aborts lift-off

European equities could provide safe haven amid global uncertainty

VW emissions scandal: the death of diesel and the impact on the auto industry

Greece to receive pay-as-you-go bailout

On a brighter note, rumours of a bid for SAB by the global giant ABI helped push the defensive consumer sector to even higher relative multiples.

Looking to the future, the UK represents 31% of the MSCI European index which makes it twice the size of the next largest country, France.

Typically, it’s unusual for us to get too concerned about country weightings within a Pan-European portfolio, but the looming EU referendum means the specific risks around UK corporates are likely to increase as we approach the 2017 deadline.

Whether you’re in favour of remaining in the EU or not, the debate is predominantly political and factual evidence seems limited or anecdotal.

What is clear over recent months is that the result has become too close to call.

The new Labour leader, Jeremy Corbyn, has made a commitment to support continued membership but it has been questioned in some quarters whether his leadership will survive long enough for this to matter.

Prime Minister David Cameron, on the other hand, whilst supportive, faces a small army of disgruntled back-bench Tory MPs who seem determined to throw down the gauntlet whatever the outcome of his negotiations in Brussels.

Simplistically we can think of Cameron’s demands in the following categories;

  • Request for EU reform to curb access to benefits of migrant workers, promote deregulation and limit intrusions from Brussels
  • Guarantee UK will not be disadvantaged given non-membership of the euro (essentially safeguarding the City of London?)
  • ‘Opt out’ from the path towards greater ‘union’

The last point is political and everyone will have their view.

If the second point is indeed directly related to the City of London then it seems the financial services industry would prefer to stay in the EU.

This is the conclusion of a study by the CSFI (Centre for the Study of Financial Innovation) in April this year when 73% of respondents said they would ‘definitely’ (49%) or ‘probably’ (24%) vote to stay in while only 12% will ‘definitely’ vote to get out.

Admittedly this is only one survey but more relevant is that this is only one industry, albeit a significant one.

Perhaps more importantly for us as investors is how British companies believe their businesses will be impacted if the UK leaves, which is the thrust of the first of Cameron’s demands.

Either companies feel they benefit from being part of a free trade area where the lack of borders is crucial, or alternatively, they view red-tape from Brussels as prohibitively expensive and believe that they would thrive with less regulation.

There’s little doubt that the global theme of deflationary pressure is placing corporate earnings at risk.

It is this last point which we believe is worthy of further debate and understanding, namely what is the impact on the real economy if Britain leaves the EU?

We do not have the information at present to make an informed judgement on this point, but we are working on it.

We hope to continue this discussion in subsequent reviews with more economic analysis to help steer the debate away from purely politics.

Concluding remarks

This review clearly demonstrates why we’ve seen an escalation in volatility in global markets, and recently emerging tensions in the Middle East between Russia and the US can only exacerbate the situation.

Fears of a Chinese slowdown are unlikely to subside anytime soon and the Fed decision on rates, whilst arguably not that important for the underlying economy, is making the market nervous.

There’s also little doubt that the global theme of deflationary pressure is placing corporate earnings at risk.

Closer to home, the domestic European recovery is showing some resilience and our portfolios should benefit from a pick up in intra-European trade and consumption.

But we are not complacent. We know QE can distort markets and will have to end at some point.

Global volatility looks set to continue but we will strive to find the most attractive companies for our clients’ portfolios, ones we believe can outperform in this uncertain environment.