European fund flows have had their longest red streak since the 2008 financial crisis, as investors and asset allocators have pivoted away from the region. In his latest investment note, Martin Todd, European Equities Co-Manager at Hermes Investment Management, argues that, despite its problems, a resurgent Europe can deliver strong long-term stock market gains.
Investors are writing off Europe again. Fund flows suggest that global managers have been net sellers of European equities for 36 consecutive weeks, as negative sentiment continues to weigh on the indices. While Europe is not without its problems, we believe investors are taking flight at a time when European markets remain attractive.
Sentiment towards Europe has been driven down by events before, notably during the credit crunch in 2008, the sovereign debt crisis in 2010, the Greek crisis in 2012 and most recently the UK vote for Brexit in 2016. However, since the global financial crisis, the MSCI Europe Index has returned 69%, showing that these market falls created opportunities for investors to buy into a long-term recovery.
Europe remains a complex picture
We are not arguing that the region is without its problems. Europe remains a complex picture. The European Union faces a very real existential threat exacerbated by Brexit. This, in turn, feeds into a growing populist political narrative taking root across the continent. Meanwhile, from an economic perspective, Italy is still trying to resolve a banking crisis that could create deep systemic problems.
While this is certainly concerning, it is important to understand that the world is perpetually in a state of political and economic flux, which markets generally weather. The impact of political events in particular are often overestimated by investors. The political stage is not the market, and despite emergence of ‘populist’ political movements across many countries, markets historically have proven resilient.
As all experienced fund managers will attest, the stock market is not the economy. Yet when macro fears cloud the investment outlook and market volatility increases, the investor’s impulse is to take risk off the table. However, we must remember that volatility is like flight turbulence – it may feel scary, but it won’t kill you.
Over the last decade, Europe has proved resilient to crises. We expect a gradual recovery, powered by a weak euro and lower financing costs via accommodative monetary policy. In addition, the slow death of austerity may provide a further boost for growth.
Historically low corporate financing costs are a particularly interesting consequence of the ECB’s unconventional monetary policy. Last month we saw Henkel and Sanofi issue negative-yielding bonds: they are literally being paid to borrow money. In this remarkable environment, companies will be enticed to raise finance to fund potentially earnings-accretive acquisition deals or undertake further share buy-backs.
Earlier in the recovery cycle
From a relative perspective, Europe may be experiencing a later economic recovery cycle than other developed economies. This offers a greater opportunity for earnings upside. For example, while the US auto recovery began as early as 2010, it is only in the last 18 months that European auto demand has picked up. More broadly, Europe offers attractive valuations and we expect aggregate single-digit earnings from the stocks in the portfolio.
We do not envisage plain sailing ahead; there are too many macro dynamics that could spark spates of volatility. As we see spikes in volatility, we expect to see sector correlations increasingly break down. For a true stock-picking conviction investor, this volatility will provide more opportunities to unearth quality companies at discounted valuations.
In the current environment, we prefer structural growth plays and those companies in control of their own destiny, through restructuring, cutting costs, innovating and positioning themselves at the forefront of changing industries and consumer trends. While the market’s focus will be on Europe’s household names, we believe there are less well-known stocks in technology, healthcare and consumer discretionary sectors that offer compelling opportunities as the European recovery gathers pace.
Living with the ‘new normal’