European Equities Fund Manager at Schroders Martin Skanberg, comments on his expectations for Europe and where he is currently seeing opportunities in the region:
Europe has started to show signs of economic recovery at a time when investors have become increasingly aware of the investment opportunities available in the region. Some risks clearly still remain, but we would argue that the pick-up in economic activity is sustainable and that there are still further gains to come for European equities. Key to this will be an improvement in the credit cycle and a return to positive earnings momentum.
Re-rating of European shares
European shares have enjoyed a re-rating since summer 2012, when European Central Bank (ECB) president Mario Draghi made his pledge to do ‘whatever it takes’ to preserve the euro. This restored investor confidence and saw Eurozone shares start to recover some of the ground lost in the crisis. However, it remains the case that European equities are still cheap compared with both their own history and when compared to US or Asian equities. In this sense, we can say that Europe is the last of the value equity trades.
The question remains as to whether the European economic recovery is sustainable. Europe is now past the point of peak austerity, has made great progress in restoring current account balances and competitiveness has also improved. Nonetheless, some tail risks remain, such as high debt-to-GDP ratios, especially in the periphery. The final piece of the puzzle is liquidity, which is yet to be restored in Europe. Credit conditions remain tough in the Eurozone, although the broader M3 measure of money supply is in growth mode. In particular, companies operating in the periphery continue to be charged much higher rates of interest than their ‘core Europe’ counterparts, making them quite hesitant to hire new workers and expand capacity. However, there are some early signs that the gap is starting to narrow and the ECB’s bank lending survey indicates that lending to corporates should pick up in the second half of 2013. Even so, the timing of the upturn in the credit cycle remains the biggest risk facing Europe.
European banks are now investible
One factor that has seen some investors shy away from Europe is the fear of further problems in the banking sector. However, Europe has taken measures to support its banks, notably via the ECB’s two LTROs (long-term refinancing operations). Individual banks have taken steps to address capital shortfall issues, with the result that the sector as a whole is reasonably well-capitalised. Only a few banks now screen as falling short of the latest capital requirements. Moreover, where banks do require extra capital, we can now be more certain that it will be raised, whether from private investors, governments, or from the ECB in its role as the lender of last resort. Capital shortfall is now a stock-specific issue, rather than a sector-wide one.
In terms of funding, it will be interesting to see if there is another LTRO by the ECB, and to what extent banks take up the funding on offer. In order to restore the market’s confidence more fully, we would need to see European banks in general adopting a more diversified funding base in terms of rising deposits and more senior unsecured funding.
Certainly there are some risks facing the sector. The most important of these perhaps is the level of provisioning by Spanish banks for their exposure to real estate developers. In some cases, the uncovered developer exposure exceeds the bank’s market capitalisation. This is an important risk, but a containable one. The ECB is undertaking an asset quality review and stress test of banks in 2014. This may prove challenging for certain banks, but should result in improved market confidence for the sector as a whole.
The hunt for value
Investors in Europe have been willing to pay a big premium for perceived safe havens. These have seen significant multiple expansion and are now priced for perfection, yet they are also beginning to fail to deliver the perfection expected.
Investors in search of value therefore need to turn their attention elsewhere. Many have sought to gain increased exposure to industrials in response to the expected pick-up in European economic activity. However, valuations in this sector are not particularly cheap compared to their 10-year average. Instead, investors may need to focus on those sectors that have up until recently faced a more troubled environment.
The energy sector should offer value, as it is currently trading at a 25- year, cyclically-adjusted P/E low. Involvement in the sector would thus be a deep contrarian call. Energy companies have invested aggressively in exploration and production in high-cost areas such as the Arctic, offshore Brazil, shale gas, etc, with the result that returns for investors are approximately the same as when oil prices were around a quarter of their current level. The sector could be worth looking at if one takes the view that energy companies will start to ease off their investment programmes and focus instead on shareholder returns. However, this is by no means a foregone conclusion.
In all cases, it is important to recognise that Europe presents an increasingly uncorrelated market. The market sell-off in late 2011 was largely indiscriminate at a time when investors feared a eurozone collapse. The recent re-rating has come about as those fears have dissipated. However, making big calls on particular sectors or countries is unlikely to be relevant now.
European equities remain unloved
We have seen some strong performance from European equities over the summer, but would argue that there is more to come. While there has been greater investor enthusiasm for the asset class recently, net inflows into European equities only really began to increase in July 2013. Allocations to Europe remain low, with EU equities still an underweight in many portfolios. This should be supportive for flows into Europe as and when quantitative easing ends in the US. On the corporate side, earnings remain depressed and there is ample room for a long-term cyclical and structural improvement. Furthermore, we would argue that the market is under-estimating the impact that a synchronised global growth recovery would have on European earnings.
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