The volatile market conditions combined with a number of other factors mean that European equity income could be an appealing strategy from here, according to Bank of America Merrill Lynch, who argue that the medium-term outlook for this area is strong.
The year so far has generally been a tough one for European stocks. While there were some early gains as investors waited for the European Central Bank to finally launch a quantitative easing (QE) programme, it went on to suffer in the wake of the Greek debt crisis and, more recently, the China-induced sell-off.
As the graph below shows, the MSCI Europe index has fallen 3.27 per cent in total return terms over the course of 2015, performing just a little better than the FTSE All Share and the MSCI World.
Performance of indices over 2015
Source: FE Analytics
However, Bank of America Merrill Lynch (BofA ML) Global Research analysts argue that this may be an attractive entry point – especially for the region’s yielding names.
“We think it makes sense in the current market environment – attractive valuations on European equities, a constructive medium-term outlook but near-term uncertainty – to seek out quality, good value names in the European market,” they said.
“High dividend yielding stocks are the prime candidates in that regard – and we believe there are many across a variety of sectors in Europe.”
They suggest there are four main reasons why European equity income might prove a fruitful strategy from here.
Firstly, BofA ML predicts 22 per cent upside on the Stoxx 600 index over the next 12 months to take it to its target of 425 points; it’s currently trading around the 350 mark. The analysts say European equity markets are “good value” at 14 times 2016 earnings and a 3.8 per cent 2016 dividend yield.
Secondly, the bank highlights ongoing volatility as a reason to look at yielding companies: “Despite our constructive stance the very near term outlook is likely to remain choppy as markets digest the macro crosswinds from EM, central bank policy and mixed economic data. We find yield strategies have performed well in previous episodes of choppy trading.”
The analysts cite 2013 – when then Federal Reserve chair Ben Bernanke spooked the markets by warning that QE would be tapered – as a good example of when European equity income held well.
As the graph below shows, the average Europe equity income fund managed to outperform the MSCI Europe ex UK index from the start of the ‘taper tantrum’ on 22 May to the end of the year.
Performance of sector vs index after taper tantrum
Source: FE Analytics
Meanwhile, the deflationary growth environment is cited as a good backdrop for the outperformance of yielding companies.
Research by BofA ML European credit strategist Barnaby Martin suggests that improving growth with weakening inflation is one of the most favourable environments for yield to work as an investment strategy, such as the end of 2014 and start of 2015 when yield strategies were the big winner in both equity and credit markets.
Finally, the analysts highlight the dovish stance of the European Central Bank as being a positive factor. “Our economists now expect the ECB to announce an extension of their QE programme beyond September 2016 at their October meeting,” the report said.
“This is driving a renewed drop in bond yields and our rates strategists now see 10-year bunds yields remaining below 75 basis point through year end. Dividend based strategies have tended to outperform when bond yields are falling and vice versa in recent years.”
There are 15 European equity income funds in the Investment Association universe and two of these have a place on the FE Invest Approved Life and in Square Mile’s Academy of Funds: BlackRock Continental European Income and Standard Life Investments European Equity Income.
Alice Gaskell and Andreas Zoellinger have managed the £1bn BlackRock Continental European Income fund since its launch in May 2011, over which time they have delivered a top decile total return of 42.20 per cent. Their average peer in the IA Europe ex UK sector has returned less than half of that.
FE Research says the fund’s performance has been “outstanding” since launch, with the income focus protecting capital in falling markets but also achieving “unexpected results” in rising ones.
Given its strong run, the fund may not always deliver the same level of outperformance but FE’s analysts added: “Nevertheless, there are reasons to believe that the fund managers should keep surprising investors through strong stock picking and flexible sector allocations.”
The £2.4bn Standard Life Investments European Equity Income fund has returned 85.84 per cent since FE Alpha Manager Will James launched the portfolio in April 2009, narrowly outperforming the sector which is up 83.46 per cent over that time.
Square Mile said: “The fund is managed by a portfolio manager who understands the needs and requirements of private individuals. We consider him a safe pair of hands.”
“The fund is unlikely to keep up in very strong rising markets but we like the manager's flexibility in terms of the types of stocks he likes to buy and he has produced a portfolio that has worked well in most market conditions.”
Performance of funds vs sector over 3yrs
Source: FE Analytics
BlackRock Continental European Income has a clean ongoing charges figure (OCF) of 0.93 per cent and yields 4.71 per cent. Standard Life Investments European Equity Income’s OCF is 0.90 per cent and it yields 3.67 per cent.
