European smaller companies finished 2012 on a strong footing, with the HSBC Smaller Companies European ex UK Index returning 14.7% in Sterling terms over the second half of the year.
The asset class has also made a very good start to 2013, rising by 13.3% in Sterling terms in January, which is ahead of not only the wider MSCI Europe ex UK Index (9.6%), but also emerging market equities (4.0%) and global equities (7.3%) over the same period*.
A stabilisation of the eurozone's debt crisis has been a major driver of recent market movements as investors responded favourably to the introduction of the European Central Bank's (ECB) bond buying programme in September last year, which effectively removed the near-term threat of a sovereign default.
The recent contraction in government bond yields in the European periphery - Italy's ten year borrowing rate has fallen from 6.6% in July to around 4.3% today, for example* - and a general improvement in credit market conditions suggests that investor sentiment towards European assets continues to improve, in our view. We believe this, combined with better economic news from key external markets such as China and the US, has the potential to boost business and consumer confidence and drive further strong performance from asset classes such as small-cap equities.
Our view here is further supported by our belief that European smaller companies remain attractive from a valuation perspective. Despite the recent performance from the asset class, small-cap valuations are still way down on 2011 levels and we therefore believe there is significant potential for the asset class to continue to deliver strong returns over the coming months.
In terms of our investment approach, we continue to place significant emphasis on company research and stock selection in the Baring Europe Select Trust. The improvement in the economic and political outlook in the region has seen us recently increase our exposure to attractively valued companies in selected southern European markets. The bulk of this exposure is focused on the Financials sector in Italy, where companies such as Banca Generali and Azimut Holding continue to perform well.
Stock selection also leads us to be favourably inclined towards the Irish market. Our principal holdings here are Paddy Power and Ryanair, companies which derive a significant amount of revenue from their fast-growing businesses overseas.
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