Recession now appears inevitable across much of Europe – and may already have started. A grim winter of potential fuel shortages and economic disruption looms. However, the impact for stock markets is not clear-cut. With a range of styles in the European sector, could one prevail over another in the tough year ahead?
There has been a huge disparity between European trusts since the start of the year, split largely on value versus growth lines. Fidelity sits at the top, having risen 3.2% for the year to date, while Baillie Gifford European Growth has lost 39.8%. While BlackRock Greater Europe has been weak over the past year, it is still second in the sector over three years, while the two Henderson trusts – European Focus and Euro Trust – have chartered a middle path. The Henderson European Focus is down just 4.5% for the year to date and up 22.3% over three years.
The economic outlook is difficult. The European Commission’s autumn economic forecast predicted that the eurozone and most EU countries would be in recession by the final quarter of 2022. “The economic situation has deteriorated markedly and we are heading into two quarters of contraction,” said EU economy commissioner Paolo Gentiloni.
Inflation is still running at 10%, though this is down from 10.6% in November and lower than economists’ forecasts. It gave investors some hope that inflationary pressures may have peaked as wholesale energy and food costs began to fall. This may moderate the ECB’s enthusiasm for raising rates and markets now expect a rate rise of 0.5% at the next meeting, compared to 0.75% at the previous two meetings.
An uncertain outlook
It is possible to make a plausible narrative both for a severe recession and a milder slowdown. Tom O’Hara, manager on the Henderson European Focus Trust, says: “A normal recession is very much in the price of European stocks. We’ve had a stock market bounce on the US CPI print and we may be through the cost of capital peak. However, the outlook isn’t clear-cut yet.”
He points to a number of risks: “If there is a colder spell, could there be blackouts? That will impair GDP. Energy storage is at good levels, but that may not be enough. It is also possible that something breaks in the financial plumbing.” He says the UK’s mini-budget experience has shown the fragility of government bond markets. Italy has high debt to GDP and may be a target for the bond vigilantes if there are signs of weakness. The EU has launched its “anti-fragmentation” tool to try to resolve the problem.
However, as Alexander Darwall, manager of the European Opportunities trust, points out, the economic situation in Europe has seldom been great. “Europe has been a chronic underperformer compared to the rest of the world, but we’ve always side-stepped it by finding great European companies. We do not rely on European economies to make progress – and that would be a particularly high risk strategy today.”
The companies in the European Opportunities portfolio tend to be global, and often, the most successful parts of their business are overseas, says Darwall. His view is that European companies excel in certain areas. “Europe has a heritage of experience. The quality of software engineers in France, for example, is second to none. The best companies are where that experience is applied worldwide.” European companies have a notably different ‘flavour’ to US companies – the leading companies may be luxury goods, fashion, media, specialist industrials or pharmaceuticals.
“We own a German company that is a leader in porcine genetics. It is a massive market in the US and this company is the best in the world at it. It is a low growth region, but there are specialist winners within that.” On that basis, he is always fully invested and is agnostic on the performance of European economies. “Novo Nordisk, Relx, Dassault all have more exposure to the US than Europe”.
Darwall believes the market tends to reward ‘true growth’ companies during times of economic weakness. He defines true growth as high quality companies with solid fundamentals, which offer a value that is measurable and monetizable: “Earnings resilience and growth get re-rated in this type of environment. We are seeing signs of that re-rating today.”
An altered landscape
O’Hara believes investors need to accept that this is a different environment. The cost of borrowing will not revert to zero, even if rate rises pause, and inflation will persist. O’Hara says: “Investors need to be in cash generative assets. The price paid for individual companies is increasingly important. Inflation isn’t going to go away, but will settle at higher rates. As a result, we are more value conscious.”
He believes there may be a lot of opportunity on a 12 month view, even if there are shorter-term periods of weakness: “A lot is in the price and we may already have seen the lows,” he adds. However, there are nuances. Technology looks expensive, he says, while some cyclical sectors still look very cheap – energy, for example. He holds BP, Shell and TotalEnergies among his top 10.
O’Hara says the biggest challenge in recent years has been to retain a valuation discipline, but not be too dogmatic about it and miss opportunities. “The valuation regime in the decade ahead is likely to be more aligned with an investment approach we’ve always practised. We’re excited that Europe is incredibly cheap and we’re excited that the upside comes, not from technology companies that are a beneficiary of the free money era, but from picking the right stocks and paying the right price.” He also holds Airbus, LVMH and construction group Holcim.
That said, European investment trust managers are not abandoning growth companies altogether. Many see real potential in the green energy complex, supported by Europe-wide initiatives such as RePower EU. This has been a favoured area for Stefan Gries at BlackRock, while Darwall has groups such as Neste – which makes sustainable aviation fuel.
The economic outlook may not prove the swing factor for European investors, but there can be little doubt that the environment has changed. A higher cost of capital and persistent inflationary pressures are likely to favour a different type of company. Increasingly, European markets will favour the careful stockpicker as ‘old-fashioned’ metrics, such as cash flow, pricing power and valuation discipline come to the fore.
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