Outlook 2020: European equities
- Governments may increase spending but stock market performance isn’t reliant on this.
- The valuation gap between different areas of the market has become very striking.
- Sectors of interest include manufacturing, oil & gas services and banks.
Martin Skanberg, Fund Manager, European Equities:
There have been plenty of reasons to dislike European equities in 2019: trade wars, Brexit and weak economic growth to name just three. But that hasn’t stopped the stock market from gaining: the MSCI EMU index of eurozone shares is up around 24% year to date (FactSet, as at 29 November).
Similarly, looking ahead to next year, we think it’s important not to let noise around politics and trade distract from the investment opportunity.
The fact that eurozone shares have been unloved is shown by the significant outflows from the asset class this year. However, there are tentative signs of this starting to improve, with the pace of outflows slowing. Investors returning to the asset class could be an important source of support for shares in 2020.
Are governments loosening the purse strings?
The European Central Bank (ECB) has already announced more easing measures, including a return to asset purchases. The key will be whether individual countries will follow suit in terms of fiscal stimulus. With former IMF chief Christine Lagarde now in charge at the ECB, it will be interesting to see if she tries to persuade governments to do more to promote growth.
The big question surrounds Germany. It is politically difficult, given the constraints on spending. However, Germany risks becoming uncompetitive in terms of income and corporate taxes as other countries enact tax cuts.
Greater fiscal spending would appear to be an obvious way to counter the political threat of populism. Spending to protect the environment is another option; Germany has its Green New Deal in place and this commands substantial public support.
Stock market performance not dependent on policy support
But even without potential help from monetary or fiscal policy, there are pockets of the European equity market that we think could do well in 2020. Eurozone shares remain more cheaply valued than their US counterparts overall. The MSCI EMU is on a 17.5x price to earnings ratio compared to the S&P 500 on 19.1x (FactSet, as at 29 November 2019).
However, there is a marked difference within the eurozone too. The price to earnings ratio is a measure for valuing companies, which involves dividing a company’s price by its projected profits. A lower number signifies a cheaper company.
Broadly speaking, companies which offer growth, have defensive characteristics and are perceived as low volatility have seen the market value their shares very highly over the past few years. This is especially the case when compared to “value” stocks (for a definition of terms, please see the end of this article). This divergence is shown in the chart below.
Food and beverages stocks are a case in point. Many such stocks have become so highly valued that any growth disappointment leaves them vulnerable to a sharp market reaction. The recent Q3 earnings season contained a few examples of defensive growth companies missing forecasts, with their shares being severely punished by the market.
By contrast, companies that are more sensitive to the economic cycle, especially those exposed to manufacturing, have become lowly valued by the market.
Economic data from the manufacturing sector continues to be weak. However, the recent better share price performance of cheaply valued, economically-sensitive stocks may be a sign that the market is starting to look through the current weakness and focus on the recovery ahead.
James Sym, Fund Manager, European Equities:
As we move into 2020, the big question on every European equity investor’s mind is whether the market rotation that led to value outperforming recently will continue. The MSCI EMU Value index returned 9.0% in the last three months, compared to 6.9% for the MSCI EMU Growth index (FactSet, as at 29 November).
We believe value’s bounce has been positioning-led (because so many investors had previously shunned this part of the market), and now economic data will have a greater part to play. We think we’re at the cusp of a regime change in markets, supported by the shift in mind-set from policymakers as expansionary tax and spending policy is back on the menu.
Relative valuations remain stretched. This should ensure the market’s change in leadership – away from quality/growth and towards value - has legs (see end of article for definitions).
We believe our strengths lie in stockpicking and using a framework focused on the business cycle to help identify unloved pockets of the market that can potentially outperform on a three-year view. We spend a significant amount of time on the continent - walking factory floors and meeting management in their offices. Knitting together what we find out from management and what we see in the economic data helps us gain a rich understanding of what is going on in local European markets.
Seeds of a European recovery
One piece of data being corroborated by conversations with company management is that European businesses are spending to a greater degree than in years gone by. The chart below shows the net balance of firms expecting to increase capital expenditure (capex) across Europe’s major markets is at elevated levels.
Meanwhile, the consumer is looking stronger, with wages rising and unemployment falling. The seeds of a European recovery are being sown, with Europeans having a little more money in their pockets.
With this in mind, where do we see opportunities?
Opportunities in stocks sensitive to the cycle
Cyclical value looks attractive for a start. This means undervalued stocks that are sensitive to the economic cycle. Our view is that we are at a turning point in the cycle, with a more synchronised global recovery expected in 2020.
A classic business cycle call is to buy economically-sensitive stocks when purchasing managers’ indices (PMIs) are low and consensus is pessimistic. PMIs are forward-looking surveys of trends in the manufacturing and services sectors, and they are at weak levels last seen in the Global Financial Crisis. Our business cycle process therefore points towards a cyclical tilt.
This takes us to some very unloved areas of the market. We think oil & gas is a sector where there is significant potential, specifically oil & gas services where many businesses are trading on very depressed valuations. However, we believe they could be in the early stages of a recovery with day-rates for rigs improving and oil majors increasing investment.
Banks are another area we think look compelling. Many have become lowly valued by the market owing to the argument that low interest rates (and correspondingly low bond yields) are squeezing profit margins beyond all hope of a near-term return to significant profitability. However, yields don’t need to move a great deal for sentiment to change. We are particularly supportive of those European banks with strong franchises and decent market share.
Other, more highly valued, pockets of the market still have attractive equity stories too, such as technology. Semiconductors have enjoyed strong performance this year and select businesses may have further to go. Areas such as software and computer services could also offer opportunities.
- You can read and watch more from our 2020 outlook series here
Glossary of terms:
Value stocks are those that trade at a lower price than their fundamentals such as dividends or profits would suggest they are worth.
In recent years value stocks have lagged behind as investors have favoured growth and high quality stocks. Growth stocks are those that are growing their sales and/or profits at a higher rate than the market average. Quality criteria include assessments of management credibility and balance sheet strength.
Investments concentrated in geographical regions, industry sectors and markets may result in large changes in value which could adversely impact performance.
The value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested.
If you are unsure as to the suitability of any investment speak to an independent financial adviser.
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