Fears are being driven by a run of weak economic data in economies such as France and Italy over the summer, which were then compounded by much slower than expected data in the one economy in Europe most investors take for granted as being robust, Germany.That the data is soft is not to be contested. The big question for us, as investors, is whether this is a mid-cycle soft patch, or whether it precedes a more worrying lurch into recession for Europe.
Of the economies where data is weak, the one of most concern to the market is Germany. In Germany the source of angst comes from the recent manufacturing data. Services data remain robust, and, in aggregate, Composite Purchasing Manufacturing Indices as well as German Private Consumption are still in expansion territory.
Feedback from corporates would point to a slightly softer than expected environment; an international recruitment company based in Switzerland indicated that it has witnessed a softer start to September, although many corporates we met at a recent conference were indicating a stable rather than falling growth outlook.
Performance of sector and index over 3 months
Source: FE Analytics
What is causing the recent weakness? To our minds there are two obvious candidates.
Firstly, the geo-political tensions in Ukraine. Whilst German exports to Russia are actually a rather small percentage of overall exports for Germany, the impact is magnified when one then accepts that exports to other central and eastern economies who also trade with Russia will be affected by the fall-out from economic sanctions.
More importantly, the impact on sentiment is profound. Ukraine is on the doorstep of Germany and so the threat of war in the region is likely to have a much bigger impact on industrialist’s willingness to invest short term. However, outside the Russian exposure, exports thus far have shown relative resilience.
The other major factor influencing growth is the fact that until very recently, German exporters were living with a very strong euro. The good news is that since June, the situation has reversed very quickly.
And, in our experience, it takes time for the full effects of a weakening currency to be seen, so we would expect the currency to act as much more of a support in the latter part of this year.
Politicians, the European Central Bank (ECB) and the International Monetary Fund (IMF) are beginning to send messages about the importance of supporting growth in the Eurozone.
Commentary from German chancellor Merkel and finance minister Schaeuble this week pointed to a desire to increase investment in Germany, with Schaeuble being quoted as stating ‘we have to fight for more growth in Europe’.
The IMF is also adding pressure on politicians to help the ECB by using ‘other policies’. So the concern is real, and acknowledged.
However, whilst growth is clearly weaker than we would have hoped and expected thus far, our view is it’s still a very large step to then conclude that Europe is rolling into another major recession.
Firstly, the euro is now a supportive factor, having been a headwind for a protracted period of time. Secondly, the Asset Quality Review (AQR) exercise on the health of the European banking system will complete this month.
We maintain our view that far from being a source of renewed tension in the financial system, the vast majority of banks will prove to have sufficient capital to allow them to have confidence in growing their loan books moving forward. The ECB takes over supervision of the banking system post AQR.
Thirdly, the Targeted Long Term Refinancing Operations (TLTRO) policy has only just started, and, in our view, the more significant tranche of ultra-cheap central bank funding for the banking system will come in December.
Whilst most market participants acknowledge the attractive pricing of the funds on offer, most doubt that there is any demand to take that funding. We’d argue that there is pricing elasticity on loans, and we are already seeing signs of increased demand for credit in the region.
In other words, in our view there are a number of factors already in motion that would argue for it being far too early to conclude all is lost in terms of European growth.
But let’s assume things are as bad as the market currently fears. Should we change our positioning? The first discussion is looking at where we already stand in terms of earnings and valuation.
Earnings have collapsed in Europe over the last five years. Failing a major exogenous shock, we find it very difficult to see why or how earnings in Europe face another lurch down; consumer demand is already subdued, investment levels are low, housing markets have already dropped and advertising levels are at cycle lows.
From a valuation stand-point, using our favoured Shiller PEs to put the current situation in a long term context, cyclical areas of the market already have earnings significantly below previous peaks, and trade at major discounts to long-term historical averages.
In contrast, consumer stocks (favoured by the market as a relative safe haven) trade at premium multiples on earnings well above previous peak.
In 2010, we bought Unilever for a number of our portfolios at a significant discount in terms of earnings multiple to the market. Today the stock trades on 19 times.
There is no valuation support in the ‘defensive’ sectors – even, increasingly, in our much-loved pharmaceutical sector, which now trades on a premium of 30 per cent to the market.
A strategist was pushing further buying of the sector on 9 October, justifying it on the basis that in the past it has traded up to 50 per cent premium. That sort of thinking worries us. As a team we are now neutral to underweight pharmaceutical, which is a significant move for us.
In reality, if one is truly worried about another imminent crisis, safety lies in cash. But that is not our call.
Parts of Europe may achieve technical recession in the short term, but for all the reasons stated above, we believe there are multiple factors which can provide growth support moving forward. In addition, earnings are already at severely depressed levels, and valuations for significant parts of the market also remain depressed.
So, we may be in for a rough ride, but we should not in good conscience change position. We are long-term, fundamentally driven investors. If you are looking for some short-term cheer we can offer some.
Sentiment levels are very negative; incredibly – to our eyes – they are as depressed as they were in the depths of the sovereign debt crisis in 2012. Whilst data may remain soft in the short term, we are of the view that much is already discounted in recent moves.
Stephanie Butcher has managed the five crown-rated Invesco Perpetual European Equity Income fund since January 2011.
Performance of fund vs sector since Jan 2011
Source: FE Analytics
According to FE Analytics, the £321m fund has been the second best performing portfolio in the IMA Europe ex UK sector with returns of 38.51 per cent, beating the sector average by more than 20 percentage points.
It has a yield of 2.41 per cent and has a clean ongoing charge figure (OCF) of 0.94 per cent.
