Market Views: Equities
Where are the post-Brexit opportunities in Europe?
The UK’s Brexit vote and US presidential election victory for Donald Trump took financial markets by surprise. In the wake of those unexpected events, Lesley-Anne Morgan, Global Head of Defined Contribution, hosted a panel session which saw Rory Bateman, Head of European and UK Equities, Philippe Lespinard, Co-Head of Fixed Income, and Andrew Lynch, European Small Cap Equities Fund Manager, discuss forthcoming events in Europe and the region’s prospects for 2017.
Volatility can be an opportunity
Rory Bateman noted that there are elections in 2017 in several European countries – notably France and Germany – which have the potential to spring surprises. It is “very difficult to position an equity portfolio ahead of unpredictable events”, he said, adding that “volatility is not going away. We would advise our clients to take advantage of that volatility and be prepared to step in when volatility is at its peak, as that is typically how we make money”.
Philippe Lespinard commented that while anti-establishment candidates may not win all the forthcoming elections, their populist agenda is migrating into the mainstream. “That means fiscal policy is turning into a renewed engine for growth as monetary policy is deemed to have run out of puff, and central bankers to some extent will welcome that”, he said.
From a small cap perspective, Andrew Lynch highlighted the importance of not investing in binary outcomes around elections. Instead, he emphasised investing in companies with good prospects, almost irrespective of the political environment. “We look for companies that have a solid growth track record and a decent balance sheet; for us it’s all about resilience”.
Limited Brexit impact on continental Europe
“Brexit is a UK phenomenon” said Bateman, adding that there are many opportunities in pan-European equities. “The rest of Europe exports less than 5% [of total exports] to the UK, so even a significant issue around the UK economy would not significantly detract from European corporates and their ability to grow”.
Economic growth in Europe is positive albeit sluggish, Bateman said, adding that the corporate environment has been “difficult, particularly for commodities and financials”. This has dragged on Europe’s ability to generate earnings growth. However, in his view 2017 should see “the best earnings growth in Europe in five years”. He argued that Europe’s gradual economic recovery is continuing, and Brexit is unlikely to derail that.
Opportunities in Irish and Italian small caps
Lesley-Ann Morgan quizzed Lynch about the high level of exposure to Irish and Italian companies in his portfolio. Lynch said that, firstly, Ireland’s economic growth has been much faster than the rest of Europe, resulting in “a big tailwind” for domestic Irish consumption.
The second reason, applicable to Italy too, is what Lynch called “Darwinist natural selection”. The companies that survived the crisis of 2008-12 – when the Irish, Italian and Spanish economies were under severe pressure – were those which had good management teams who restructured and cut costs. “We think it makes a lot of sense to back those management teams now to take advantage of the recovery”, Lynch added.
Picking up the Italy theme, Bateman highlighted the forthcoming constitutional referendum. Matteo Renzi, Italian prime minster, has pledged to resign if he loses the vote. In Bateman’s view, this would cause the much-needed structural reform agenda to slow. However, the unresolved issues facing the Italian banking sector may pose a bigger risk. “Until the non-performing loans are crystallised, we’re not going to be that comfortable about the banking system in Italy”, he said.
Pressed by Morgan on opportunities in Spain, Lynch noted that “the good quality companies in Spain have already been well-appreciated by the market” and so the valuation opportunity is less attractive.
Are we facing a bear market in bonds?
Asked about the rise in bond yields since Brexit, Lespinard noted worries that the 30-year bull market in bonds could be coming to an end. With fiscal policy coming to the fore and economies recovering, he noted rates will need to rise and yield curves will steepen.
In his view, this means that “investors are likely to favour short-dated bonds or high yield1”. He sees a likelihood of a strong preference for high yield over investment grade debt in Europe, adding that high yield debt also tends to be short-term. Another attractive option for investors could be convertibles, he said, noting they offer short duration alongside equity exposure.
Lespinard also pointed out the importance of seeing the rising yields from the institutional point of view. He added that insurance companies and pension funds have been wanting rates and yields to be higher, “as the curve steepens, half the retail investors will try to shorten maturities … but on the institutional side there is hundreds of billions stuck waiting for yields to go up”.
Undoing the Washington Consensus
Thinking about potential risks ahead, Lespinard pointed to signs that we may be moving away from the Washington Consensus, which has favoured free trade and independent central banks. “That has worked wonderfully well globally in lifting people out of poverty, but it has created local inequality”. Amid a growing push back from those who have lost out, he noted that any moves to clamp down on free trade will “challenge companies, or indeed countries, that have built their business model on exporting their way to growth”.
Bateman added that demographics in Europe pose another challenge amid an ageing population. However, he noted that “there are always companies that can take advantage of these structural changes, both within Europe and globally”. He mentioned luxury goods, life insurance and renewables as industries adapting to changing themes.
Turning to the outlook for inflation, Lespinard also commented that any reduction in free trade could see rises in prices. Taking the example of the Chinese dumping of steel, he noted this has been “great for consumers, but not great for producers in Europe”.
ECB tapering on its way
Lespinard noted that the European Central Bank (ECB) is likely to start tapering its bond-buying programme by spring 2017, partly because it will soon run out of bonds to buy but also because of the negative side effects of quantitative easing on banks.
He commented that tapering could see sharp market moves and misallocation of capital. In his view, investment grade debt in European industrial companies could see the most volatility when the ECB starts tapering, and that could be a great opportunity. He added that interest rates would stay low and some sectors could benefit, saying “a steeper yield curve would be good for financials”.
Best investment ideas for 2017
Lynch offered two top sector ideas: renewables and e-commerce. He commented that while Donald Trump is not keen on renewables, two Republican states – Iowa and Texas – have the biggest installed wind capacity and senators from those states still like renewables. In addition, he noted that more countries are signing up to the Paris climate change agreement, saying “renewables demand is one of those structural trends that we think will keep going, irrespective of what Trump does”. Moreover, as renewables efficiency increases, the need for subsidy falls.
In terms of e-commerce, Lynch said that “while you can’t buy Amazon in Europe, you can buy the companies that do logistics for them, or supply technology, or make cardboard boxes”. While this has been a fast-growth industry, there is still “a long way to go”, in Lynch’s view.
Bateman highlighted the overall opportunity potentially on offer in Europe. He noted that one problem facing US investors is the more expensive starting point in terms of valuations, as well as the fact that earnings are around peak levels. By contrast, European equities are more cheaply valued and earnings are depressed relative to their peak. He also pointed to the recent signs of rotation in the market, “In the third quarter we’ve seen some of the more cyclical areas of the market produce better-than-expected earnings growth, while some quality and defensive names have struggled2”. In his view, this is likely to continue into 2017.
Within the market, Bateman concurred that renewables are an interesting opportunity, along with other trends such as electric vehicles. Luxury goods is another sector he likes, noting that the sector trades at a fairly depressed valuation after the Chinese clampdown on gift-giving. He sees “digital e-commerce opportunities within luxury which are underdeveloped so far”. Luxury also has a cyclical element as the goods are discretionary items, which is another attraction in an era of rising bond yields.
Finally, Lespinard commented that, as well as high yield, asset-backed securities could perform well in 2017 if US construction picks up, given Trump’s pledges on infrastructure spending.
1. Investment grade bonds are the highest quality bonds as determined by a credit ratings agency. High yield bonds are more speculative, with a credit rating below investment grade.↩
2. Cyclical stocks are those whose share prices are directly related to the economic or business cycle. Defensives are those whose performance is not highly correlated to the broader economic or business cycle.↩