European recovery uncertain

While pessimism about the future of the recovery in Europe refuses to go away, European equities have bounced and no longer look cheap. The uncertainty of the impact of withdrawing government stimulus packages and persistent weakness in labour markets – unemployment is around 10 per cent – continues to unnerve investors.

Active European equity managers are therefore being highly selective, moving away from cyclicals to stable sectors such as consumer goods, and companies with strong or growing demand from emerging economies.

“One of the key issues of 2010 will be the outlook for policy stimulus and the extent to which private sector demand can begin to replace it,” says Nigel Bolton, head of the European style diversified team at BlackRock Strategic Funds.

“It is our view that central banks will wait to see clearer evidence of a sustained economic recovery and a stabilisation in unemployment before implementing tightening measures. Looking forward, we expect market returns will continue to be driven by stock specific factors.”

For some countries, such as the UK, Spain, Greece and Ireland, the threat of a sovereign credit re-rating is a real concern. “The UK has a tremendous amount of debt at household and sovereign level and while quantitative easing has had some impact, it has been laboured,” says Jeremy Whitely, head of UK and European equities at Aberdeen Asset Management.

“The UK is coming out of recession only in a meagre way whilst recovery is much stronger in Germany and France,” he says.

The risk factors suggest Europe’s malaise may be deeper than initially thought and include the panoply of huge sovereign and personal debt, currency devaluation and potential inflation, as well as the bureaucratic and monetary restrictions of the European Union’s attempt at a one-size-fits-all strategy.

Geographically, Ireland and Spain, those countries previously at the forefront of the property boom, are now suffering disproportionately, but there are also creeping concerns about Portugal. In addition, there are particular challenges for certain sectors that are heavily represented on the European bourses such as the impact of the new capital rules on banking.

Eastern Europe does not share the rest of Europe’s structural debt problem, however. The average amount of government debt in the region is 40 per cent of GDP (Gross Domestic Product), compared to the Eurozone for example where the figure is around 80 per cent of GDP.

“We’re currently in the midst of a revision about what investors think about Eastern Europe, almost on a weekly basis growth forecasts for the region are being revised upwards,” says Marcus Svedberg, chief economist at East Capital.

“Recovery will be orderly, continuing in the second half of this year and coinciding with the phasing out of the various stimulus packages. We believe that real growth (not stimulus driven-growth) will be strong enough to sustain the recovery.”

Some good news

Even in the eurozone, there have been surprises on the upside, however. Philippe Brugere-Trelat, portfolio manager at Franklin Templeton, points out “although difficult from a growth perspective, there are positive factors such as low interest rates and the great resilience demonstrated by a large number of European companies during the crisis. “Through aggressive cost cutting and destocking, they were able to protect their operating margins, much more than expected,” he explains. “This became apparent starting last summer when quarterly results surprised on the upside.”

Whether the competitiveness of emerging markets still relies on cheap manufacturing is also a moot point. Aberdeen’s Mr Whitely believes that German, Swiss and UK companies provide technical value added in many industries, citing examples such as aero manufacturer Rolls Royce and Swiss lift maker Schindler.

But although industrial production has been expanding and manufacturers – notably in Germany – have helped lead the eurozone out of recession, European consumers remain cautious. The focus has therefore turned to those European consumer goods companies that generate hefty chunks of their revenues from emerging markets.

On average, European quoted companies generate 20 per cent of revenues from emerging markets, and 40 per cent from outside Europe. Many managers have been focusing on names such as Unilever, which generates 40 per cent of revenues from emerging markets, and British American Tobacco, which generates 65 per cent. Other popular examples are Nestlé and Prudential. Emerging market demand for basic materials and IT is also expected to accelerate.

In valuations terms, European stocks are no longer strikingly cheap, on an average price to earnings ratio of 11.5, but there are some opportunities where stocks have been oversold. For example, Mr Brugere-Trelat at Franklin Templeton says he is picking up opportunities at current valuation levels in some industrials that were beaten up such as Daimler and Siemens, adding these to his overweight positions in cash-rich tobacco and food stocks.

Some managers are hopeful that the acquisition of Cadbury by US food company Kraft marks the resumption of M&A activity and a series of new opportunities now that capital markets have reopened. Balance sheets are in good shape and there is optimism that businesses will start to make acquisitions driven by industrial logic rather than purely financial considerations.

Risk of disappointment

Fund managers are split on their confidence in analysts’ consensus forecasts of 25 per cent earnings growth this year and next. Alexandra Annecke, fund manager at Union Asset Management, is sceptical. “The risk of disappointment is there. The challenge is that the cyclical sectors have risen hard already and do not look cheap this year,” she adds.

“I believe we are in for a slower growth environment and so in general we want to invest structurally in parts of the market where there has been significant underinvestment for example in technology where companies have not invested significantly since 2000,” says Nicolas Walewski, managing partner at London-based Alken Asset Management, pointing out the similarity with the 1930s when innovative companies such as IBM did so well.

At another extreme, Merrill Lynch Wealth Management takes the view that forecasts of this level are well within reach and predicts particularly strong profit growth in basic resources, energy and IT sectors – a good 35 per cent, specifically 35 per cent in oil and gas rising to 50 per cent in the technology sector.

For many managers, the portfolios are split between big secure companies with good visibility in their revenues – the Nestlés and the Vestas – and smaller companies with greater potential for growth. In the first strand, for instance, might be satellite operation Eutelsat, which in the long-term is likely to grow its revenues on the back of increased demand for capacity whatever is happening to interest rates, and also has excellent barriers to entry.

Leon Howard Spink, fund manager at Schroders, points out that a manager has only to come slightly off the biggest companies to easily find good companies amongst the mid-caps with potential for growth. For example, he particularly likes oil services companies as new oil sources are increasingly inaccessible in deep water offshore.

Other favourites are healthcare, where dividends are high, mergers are reducing costs and the FDA is becoming more relaxed. Fund managers particularly like stocks with an exciting niche geared to Europe’s aging populations such as Swiss hearing-aid maker Sonova and German and French lenses makers Fielmann and Essilor. Another example of a sector geared to growth is freight brokers such as Kuehne + Nagel.

Low cost solutions

“When the middle classes delever then certain types of stocks historically outperform,” says Alken’s Mr Walewski. “The winners will be the low cost solutions, like easyJet and Ryanair, and companies that can harness the internet.”

In a low growth environment, companies with pricing power are also highly sought after. Mr Walewski says that 2009 saw the rise of many cyclical stocks but you can doubt their pricing power over the long-term.

“They will probably start to struggle. A company like Rolls Royce has a lot of pricing power. For example, with the big Airbus – it has almost 100 per cent market share worldwide and that will last 15 years, plus spare parts for 25 years after the planes are sold, and it is non-discretionary as it is all driven by safety and maintenance regulations.”

Active management the answer to clients’ concerns

Investors are coming back to Europe, says Nicolas Walewski, managing partner at Alken Asset Management, because their holdings in equities are at historic lows and whilst they had been buying a mix of bonds and emerging market equities, they are now coming back in a reactive rather than proactive way, chasing the market after it has risen. Much of the interest is from Asia, and not just from the Middle East.

The major consideration for investing looking at European equities is currency depreciation, particularly the euro, which is seen as overvalued and vulnerable, a perception accelerated by concern about sovereign wealth, says Bill O’Neill, portfolio strategist at Merrill Lynch Wealth Management at EMEA. Clients, concerned about hedging their euro exposure, responded warmly when the wealth manager floated this suggestion, he says.

Hedging can be achieved by forwards market or by funds with non-euro share classes, which is perhaps the neatest solution.

This thinking has flowed through to country themes, says Mr O’Neill, primarily the UK versus the non-UK eurozone equity markets. Clients are also looking at single country exposures, particularly around financials where a key driver is the hunt for yield. A reluctance to boost exposure to equities and a great deal of selectivity, has prompted interest in preference shares and corporate bonds, particularly in the financial sector.

“The equity culture is not back,” says Mr O’Neill. “Rather, it has been a case of robbing Peter to pay Paul as investors switch their portfolios around but the overall bucket of exposure to European equities is static to declining.

“It’s a year for active management, and clients are looking at alpha strategies around stocks themselves, picking up individual companies with a view to performance relative to the market, rather than betting on the direction of the market itself,” he explains. “Valuation is less of an issue but still important as there are some good undervalued stories with solid balance sheets, and earning momentum, an important metric this year.”

Alexandra Annecke,

Union Asset Management