Outlook 2016: Business Cycle (Europe ex UK Equities)
- The European Central Bank is trying to stimulate reflation; should this occur it could benefit value areas of the market that have been out of favour.
- The economic outlook for Europe looks reasonable and pent-up demand could lend support.
- We see potential opportunities in energy producers, even without an upturn in oil prices.
The outlook for European equities in 2016 is more nuanced than it has been for several years, particularly given the potential for incremental stimulus from the European Central Bank (ECB) and its knock-on impact on bond yields and therefore equity prices.
Whatever the short term effects might be, quantitative easing has the implicit aim of embedding inflation. This has important implications for portfolio construction.
For the past few years we have been making a call on recovery, essentially by comparing equity valuations today to what we would consider a normalised level of profitability.
We favoured those stocks where the risk-reward looked to be the greatest, were economic recovery to take hold in Europe.
This process has served us relatively well, but has led us into the value compartment of the market.
We still favour limited exposure to growth which is approaching bubble valuations.
As we look into 2016, and despite the fact the “recovery” profit pool has nowhere near recovered to historical levels, we think we now need to encompass value more broadly, making sure to avoid value traps.
This will not change our core positioning since we do not see a big turning point in the business cycle currently.
We still favour limited exposure to growth which is approaching bubble valuations. The risk is that bubbles can grow bigger.
Having said that, we remain open-minded and would consider opportunities within this compartment of the market should we find them at attractive valuations.
Value and consumer stocks could perform well
Our positioning is heavily influenced by our belief that inflation will return as the ECB is committed to it.
We think we are in the process of shifting from one investment paradigm to another i.e. from “lower for longer” to reflation. The key beneficiaries of “lower for longer” have been growth stocks, which have outperformed value by 15%/19%/31% over the past one/three/five years respectively.
The key beneficiaries of reflation should be value stocks, in particular financials and this is one pocket of the market where we think absolute value remains.
For us, the other key driver is economic momentum. We continue to see a relatively reasonable outlook for Europe.
One area of the market we have been focusing on is oil & gas producers. We see the potential for an enormous step change in cash generation.
We think the market underestimates the recovery potential of the European consumer and the level of pent-up demand that exists.
Before 2015, Europe had been through six years of credit crunch. That said, we cannot discount an impact in Europe from the weakness in the US and China.
Recent data has been more encouraging with the US Economic Surprise Indicator moved back to positive for the first time this year recently and Chinese data picking up more broadly. We remain watchful.
Opportunities in energy producers
One area of the market we have been focusing on is oil & gas producers.
We see the potential for an enormous step change in cash generation, without an improvement in the oil price. In fact one thing we are sure of is that we have no ability to predict the future oil price!
Like other commodities, oil went through a massive bull market for 15 years (excluding the financial crises) during which time the price more than quadrupled. Despite this, the cash generation of the sector remained flat.
Where did all that value accrue? The value went to the oil service companies (still unattractive in our view, incidentally) as the bottlenecks across the supply chain endowed these widget makers with pricing power.
The level of operating expenditure and capital expenditure (capex) required per barrel of oil rose significantly.
There is a historical precedent for “lower for longer” with respect to oil prices. Between 1987 and 1997, oil remained roughly flat in nominal terms and declined 3% in real terms per year.
During this time, upstream (i.e. exploration and production) profit margins grew from 6% per year as, amongst other things, costs fell.
Looking at expectations in the market today, the extent of cost reduction that is possible (20%? 30%? 50%?) is nowhere near being reflected in current share prices.
Further, during 1987-97, free cash flow more than covered dividends, which grew at 9% per year, despite capex rising 6% per year.
In short, we have identified a section of the market which is very un-consensual and offers 50-100% upside over the next three years.
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