Equity markets tread water as ECB prepares to move

Recent strong hints from Mario Draghi, the ECB president, that the central bank could loosen monetary policy to stave off the threat of falling inflation when it meets in June have been broadly welcomed, but in the meantime the announcement has had the effect of putting markets on hold.

Eurozone inflation picked up slightly to 0.7 per cent in April, but still lags well below the ECB’s target level of just under 2 per cent. Mr Draghi has repeatedly highlighted the strength of the currency as a drag on inflation, but the euro remains stubbornly high, bolstered by large market inflows this year.

The central bank has a number of options, ranging from a cut in rates to full-blown quantitative easing, to encourage prices to rise. The prospect of such action has been a key support for European equities during a lacklustre first-quarter earnings season, and Mr Draghi’s promise to take action in June pushed the Stoxx Europe 600 index to 3,204.3 points, its highest since January 2008.

The issue is whether these highs can be sustained, particularly in view of major earnings disappointments. According to Thomson Reuters, around half of the two-thirds of companies in the Stoxx Europe 600 index which have posted first quarter results missed their earnings forecasts.

“The challenge now is that earnings are slow to materialise,” says Ronnie Sabel, senior portfolio manager, European equities at Russell. “Forward looking indicators suggest earnings should be revised upwards. As it stands, either earnings will look better or leading indicators will come down.”

The change in valuations means previously easy to find opportunities in style, sector and countries are now not as obvious, he adds.

“A natural delay is expected before the improvement flows into company earnings; it is just taking longer than anticipated, while the strength of the euro has also made it more difficult for companies,” explains Mr Sabel.

It seems unlikely that earnings will drive further strong gains in share prices in the short term, as some of the most popular stocks sit on relatively bloated valuations, but overall the market is currently trading at 15 times earnings and just over 13 times next year’s earnings.

“On the positive side, consumer confidence and PMI (purchasing managers’ index) data in Europe is better than anticipated, but on the other hand we have doubts about the strong currency and low inflation,” says Max Anderl, lead portfolio manager of the UBS European Opportunity Unconstrained fund.

He warns the strong euro is proving to be a headwind for exporters. Although many analysts are building this into their forecasts for 2014, the currency may not weaken for a long time. Even countries that traditionally were not exporters like Spain now rely on exporting more, adds Mr Anderl.

“The other factor is very low inflation, and falling,” he says. “Low inflation or deflation will not make the debt burden go away, and any slowdown in the economy would bring down inflation further, or if China continues to devalue against the dollar, that would export deflation to some countries.”

Ultimately, concrete action will be required to dent the euro sufficiently, and by putting a date on it, the ECB has created pressure on itself to act, or lose credibility.

Europe has traditionally been a stockpicker’s market, as there is so much variation in regional markets and not all corporates serve their shareholders, but the market is currently being driven by  macro trends.

“I’m not sure it is a stockpicker’s market,” says Nicolas Walewski, founder of Alken AM. “Most stocks underperform the market, while a narrow band of large stocks are outperforming. So in fact, it is a stockpicker’s nightmare.”

Investors have been happy to play the recovery of the European economies through domestic cyclicals, but lately the low inflation numbers and the fact that the ECB does not seem ready to embark on a large-scale QE, has created nervousness about where the inflation level is going to settle, he says.

Investors do not know whether the situation from April into May will prove to be a short term trend or a lasting move, as they don’t know whether a resolution will be forthcoming. This makes it a tricky market, explains Mr Walewski.

Some sectors have been rising on the macro news but it is difficult to see where alpha can be obtained, he says. “As people are uncertain, they are re-balancing into sectors that are long duration, with high multiples, benefiting from low interest rates, but in this rebalancing of portfolios there is a struggle to find leadership.

“Investors have been playing the European recovery through consumer discretionary because of the inaction of the ECB. People are worried, whether or not that is justified, and of course, if the ECB makes a monetary mistake, the recovery won’t last.”

However Europe is still seen as more attractive than many other markets, notably the US.

“Trying to time the flows is very dangerous in Europe  as it consists of many different local markets,” says Wahid Chammas, co-portfolio manager of Janus European Equity strategies. Yet some companies are creating a lot of value, he explains, for instance companies making fracking pumps and steel pipes for the shale industry, or those involved with tablets which are changing the way consumers access the media or do their shopping.

“In the US, companies have been taking costs out for some while, but in Europe they have only just started, so Europe has a huge opportunity to boost margins,” claims Mr Chammas. “Europe is growing at the rate of 1-1.5 per cent but earnings are growing 10-15 per cent. In the US, GDP is 3 per cent but earnings have fallen to 6-7 per cent  so Europe is the better place for action.”

Like several other fund managers, he particularly likes the luxury goods market. “Even though China has cracked down on gifting, luxury goods are still an unbelievably competitive market with immense barriers to entry and they are able to preserve their pricing.”

Financials comprise one third of the market, so a fund manager’s view on the sector makes all the difference. By and large managers have increased their exposure to financials particularly in southern Europe, with those early into peripheral banks rewarded for their bravery.

Mr Chammas explains how he invested in a Spanish bank in Latin America two years ago in a country which made investors nervous, but today the same investors would be critical that it was not a bank in a peripheral country.

“Investors are buying bank stocks as a reaction to falling government bond yields,” says John Yakas, manager of Polar Capital’s Financial Opportunities fund. “Fundamentally, the picture for these banks’ loan books is still quite mixed. In general, the level of problem loans has already peaked or is close to peaking. Spain’s asset quality trends suggest it has peaked and is now on an improving trajectory.” 

The other issue is the cost of funding, which has fallen by at least 200 basis points, while balance sheets have shrunk. Some have also raised capital so their position is better than three to four years ago. Government bond yields are down and people are now more confident to put cash on deposit.

“The key trends are the improvement in non-performing loans and margins,” says Mr Yakas. “This is not just froth, it is a real improvement. But looking forward, stocks have now caught up with events and there must be an improvement in underlying
profitability.”

He particularly likes Italian banks which are on some of the lowest valuations. “They are still very cheap against other banks – at a 30-40 per cent discount to Spanish or Greek banks. For example, Intesa is trading on 0.8x book value compared with normally 1.2x book value,” says Mr Yakas.

“One hindrance to growth is that banks are not lending as freely as we’d like as regulation has been fragmented and they have been deleveraging ahead of the stress tests,” says Frédérique Carrier, head of European equities at RBC Wealth Management.

“A possible cut in interest rates by 25 basis points next month is unlikely to kickstart lending, but the stress tests could be more of a catalyst. Last week the European Banking Authority announced the scenarios it will use and it all seemed sensible enough, but we will not know for sure until the stress tests results are announced in October.”

Market nervousness has also created demand for funds that can short stocks, such as  Fidelity’s Fast Europe fund. “The fund gained traction in 2009 because the same apprehension around using tools such as shorting and options that meant customers  had viewed it as risky, could be used to protect capital in declining markets,” says Fidelity investment director Toby Gibb.

Flexibility on the short side has been big contributor to fund’s performance. It is currently exposed to shorts in mining and mining equipment, and in pharmaceuticals pushed up by the takeover frenzy .

The fund tends to be more diversified on the short side as returns from shorting are asymmetric, but has been adding long exposure recently in financials on the restructuring story and in consumer discretionary.  “The  auto and autoparts sector is one of few areas of cyclicality that still offers value,” says Mr Gibb. 

On the up

“Europe is our strongest conviction at the moment,” says Michael O’Sullivan, CIO UK and EEMEA at Credit Suisse.

“Even though in some quarters valuations are moving up, there is no sign of a let-up in fund flows and in our view little sign that the earnings recovery is faltering.”

Earnings are just above their long-term average, but profit margins are less than in the US so there is greater scope for improvement, and the region has managed to get through the strong currency without much whimpering, he explains. In comparison, US markets are flat and its macro data volatile.

“The ECB has reserves of credibility with the market, but we think we’ll get QE later than people think. The euro/dollar is still well bid but by the end of the year we should see the market expect the Fed to raise rates in 2015 which should see the euro moving lower against the dollar.”

Mr O’Sullivan thinks the currency will end the year at 1.34 euro to the dollar. “Whether the ECB engages in QE will depend a lot on the balance of fund flows. Fund flows have been strong because of M&A activity and this will keep the euro lower. At the moment, Europe is still the liquidity pool in the market but investors could for instance migrate to emerging markets.”

The stress tests in October will be worth watching, he predicts. European banks are currently trading at a price to book of just below 1 and any shakeout will be a good opportunity to get back into the sector.

Carlos Salas, senior equity analyst at London & Capital, believes monetary conditions will remain accommodative owing to poor unemployment data, ECB deflation fears and fragile SME liquidity status.

“We recommend investors be selective, choosing investment vehicles with a savvy exposure to European markets,” he says. “We have increased European exposure in early 2014, allocating capital to defensive sectors like consumer staples and telecommunications, focusing on reasonably low-priced firms offering operating momentum, substantial dividends and strong fundamentals, for example Nestlé, Danone or Telenor.

“For diversification we have also invested in more cyclical industries but via companies with high quality financial metrics and market influence in niche industries that offer margin protection during periods when macroeconomic data may turn soft, for example, ingredients-manufacturer Givaudan and media company Reed Elsevier.”

“We believe equity gains will be governed by earnings growth,” says Jean-Christophe Gérard, co-head Private Bank Investment Group, HSBC Private Bank. “We forecast 10-15 per cent for 2014 globally, and advise investors to be long European equities because global GDP growth is accelerating, margins are starting to expand, dividends forecasts are improving  and the euro and pound should stop appreciating against the dollar.”

Discipline in capital expenditure pays dividends because expansive capex plans are risky when growth is so lacklustre, he says. Investors like comapanies that are easing back on capex and growing cash flows.

“There is a danger that cyclicals’ earnings will disappoint in a weak recovery,” says Mr Gérard. “We favour cyclical sectors with low valuations, such as materials. Growth stocks also risk disappointment in an anemic recovery and relative valuations still favour value.” He highlights energy and banks among his value picks, along with some stocks with exposure to China, given how far they have fallen out of favour.

VIEW FROM MORNINGSTAR: Value stocks make a comeback

With low interest rates and the return of investor confidence in Europe, over the last five year period, the funds in the Morningstar Europe Large-Cap Blend category posted an average annualised return of 12.98 per cent.

Funds in the Europe Large-Cap Growth category outperformed all other investment styles with a return of 14.27 per cent.

It now appears as if value investors hold the upper hand. During the last 12 months, funds in the Morningstar Europe Large-Cap Value Equity category achieved returns of 18.48 per cent, while Europe Large-Cap Growth Equity returned just 9.22 per cent.

However, when looking at the best-performing individual European funds, it is not clear that one investment style has dominated. One of the top performers was Alken European Opportunities, which applies a flexible investment style floating between the value and the growth areas. The fund returned 19.88 per cent, landing well ahead of its peers in the European flex-cap category. Manager Nicolas Walewski follows an opportunistic high conviction investment approach that is not constrained by an index.

Another good performer was the Franklin Mutual European Fund, returning 16.93 per cent and beating the average European equity fund, but lagging the value category.

Still, investors should bear in mind that this return was achieved alongside a much more attractive risk profile. Though the fund can trail its peer group during strong market rallies, manager Philippe Brugere-Trelat’s conservative, valuation-sensitive approach has given it a long-term edge over the competition. 

Barbara Claus, fund analyst, Morningstar