This week, we were reminded of the challenges that Europe faces, with Germany making the headlines for cutting its growth forecast for 2024 from an already meagre expansion of 0.3% to a contraction of 0.2%. If this comes to pass, it will be the second year in a row that Europe’s ‘motor for growth’ has seen its economy shrink, with implications for other European economies. It will also give Germany the dubious honour of being the only G7 economy that contracts – also for the second year running.
There is little doubt that, when compared to the US, European economies have had a difficult couple of years. The manufacturing sector has declined, dragging on overall economic activity, and confidence is low. The euro area manufacturing PMI for September 2024 was 44.8, down from 45.8 the month before and while still modestly expansionary, the outlook for services has shown a marked deterioration with its PMI coming in at 50.5 in September, down from 52.9 a month earlier. Germany has felt more pain than most as it exports a lot to China – whose economy has its own well-publicised problems (although conceivably could pick up if the latest bout of stimulus that Andrew discussed last week bears fruit). Investors have been heavily focused on the benefits of AI and the bulk of innovations in this area seem to be coming from the US – although all regions should ultimately benefit from the productivity gains this is bringing.
The war in Ukraine continues to grind on and, while progress has been made on adjusting supply chains and improving energy security, Europe continues to be weighed down by higher energy prices, which affect economic activity across the board. Europe is also pushing forward more aggressively than other regions in tackling climate change. We think this is commendable, but it comes at a cost, so the headwind of higher relative power prices looks set to continue.
Europe’s political landscape has also become more challenging. Italy has a governing party with far-right roots. France’s far-right National Rally (RN) and its allies won the first round in the legislative elections by a clear margin. The left quickly rallied round and formed an Alliance that thwarted RN in the second round, pushing it into third place, but President Macron’s centrist coalition also suffered, coming in second place and has been weakened as a result. This served as a wake-up call for many investors and French equities suffered in the aftermath. Germany’s Alternative für Deutschland (AfD) polled strongly in recent state elections.
Against this backdrop, it was encouraging to see a decent set of annual results from The European Smaller Companies Trust (ESCT). For the year ended 30 June 2024, it provided an NAV total return of 12.0%, outperforming its MSCI Europe ex UK Small Cap benchmark by 1.9 percentage points. Shareholders did even better as the discount narrowed and ESCT provided a share price total return of 19.5%, aided by NAV accretive share repurchases.
In many respects this seems counter-intuitive when set against the macroeconomic and political backdrop. It also illustrates that even when the outlook is challenging, good active managers can make progress by making good stock selection decisions – for example, identifying companies with strong defensive moats and/or important products that will be to make progress irrespective of the economic environment. All of this led me to have a look at how ESCT had performed versus its peers, where I found a few more surprises.
During the last year (data to 9 October 2024), ESCT is only the third-best performing fund in NAV total return terms within the European smaller companies peer group (returning 22.6%), with Montanaro European Smaller Companies Trust (MTE) and JPMorgan European Discovery Trust returning 23.9% and 26.0% respectively. All three benefited when European equities rallied strongly towards the end of 2023, as markets became more optimistic about rate cuts during 2024, and have continued to make progress since. All three have posted superior share price total returns as their discounts have narrowed during the year. The one exception to this trend within the peer group is European Assets Trust (EAT). Unfortunately, EAT has been the laggard within the sector for some time and its difficult relative performance has continued during the last months – its NAV total return of 12.4% being roughly half that of its peers – and so it is not surprising that EAT’s discount has also widened.
Of all the small cap funds, MTE stands out for me particularly because its long-term returns have been the highest in the sector, in spite of, in recent years, facing an environment where its focus on higher quality growth companies has not been rewarded by the market. This has the potential to change.
We think that JEDT, ESCT and MTE should all benefit if inflation continues on its downward trajectory – possibly returning to the premium ratings they previously enjoyed – but MTE’s strategy could find further favour if investors start to place more value on quality, perhaps if the outlook becomes less certain. When we spoke to MTE’s manager, George Cooke, recently, he pointed out that, despite the challenges Europe faces and regardless of the recent volatility in markets, MTE’s holdings have shown few signs of diminishing quality or revenue growth in aggregate.
Another surprise was that, when looking at the investment trusts that are focused on European large caps, these have also provided strong returns – the median return was 19.0% – but are behind the European Small Cap funds, whose median return was 23.2%. Some might have expected a less certain environment to have favoured large cap stocks, but this does not appear to have been the case. However, like the small-cap-focused funds, the large caps benefited from an expectation of falling interest rates towards the end of last year.
Of these, we find European Opportunities Trust particularly interesting. It has lagged its peer group this year, but it is the most-growth focused fund within the group by some margin and should be well positioned, if not the best-positioned, to benefit if interest rates continue to fall. It has a strong focus on B2B businesses and so has not benefited from the strength of the European consumer, which has been held up by strong employment numbers, but all of this could change, potentially triggering a narrowing of the performance gap as well as the discount.
