Investors shouldn’t follow the crowd into European equities, according to Rathbones’ Julian Chillingworth (pictured), who says that the region is still in ill health and continues to face numerous challenges which means he expects increased volatility and poor returns. 
Thanks to their relative undervaluation to other developed markets, signs of economic stability and very accommodative monetary policy from the ECB, European equities were the most favoured asset class among FE Trustnet readers heading into 2016.
Indeed, the popularity of the region is also shown by the positioning of most multi-asset and global managers with the large majority increasing their exposure to Europe (as well as Japan) relative to their benchmarks heading into the year.
Europe has tended to be one of the principle sources of bad news for investors over the past five years or so and the MSCI Europe ex UK index has significantly underperformed global indices as a result.
Nevertheless, many believe funds that specialise in the region offer the best opportunities as not only is the future looking brighter for the eurozone economy but the common belief is that the ECB, with its extraordinary and large-scale stimulus programme, is providing a floor to equity prices.
Performance of indices over 5yrs
Source: FE Analytics
However, Chillingworth – chief investment officer at the group – urges investors not to fall into the trap of believing European equities are about to deliver stellar gains. As such, it remains considerably underweight the region with its portfolios.
“In contrast to the US, European policymakers have dithered when faced with a series of problems following the 2007 financial crisis. As a result, the region’s banking sector is in ill health and the ECB has recently introduced negative interest rates as an extreme measure to boost growth,” Chillingworth said.
Chillingworth has two primary concerns with the European equity market.
Firstly, Chillingworth believe the decision from the Mario Darghi and the ECB to introduce negative rates will have long-term negative effects and, secondly, the banking system – which seemed to be on the verge of collapse in 2011 during the sovereign debt crisis – is still built on shaky fundamentals.
“The eurozone economy is struggling and remains reliant on the ECB’s largesse in stimulating monetary growth,” Rathbones said. “Central bank president Mario Draghi’s latest stimulus measures include an expansion of its monthly asset-buying programme and reducing its deposit rate further into negative territory.”
“Since the start of the year, the region’s equity markets have been volatile. As well as weaker conditions in southern countries, a slowdown in global growth has hit northern exporters.”
Performance of indices in 2016
Source: FE Analytics
“The other concern for investors is the stability of the European banking system, which has come under considerable pressure recently. A further tranche of loan impairments could be in the pipeline.”
As mentioned before, there are many who disagree with Chillingworth’s cautious stance on European equities. These include Nikko Asset Management’s Global Investment Committee.
“The firm’s key investment committee has an overweight stance on eurozone equities. The positive earnings effect of euro weakness, expected relief from a vote to reject Brexit and continued regional growth being the main factors to support the eurozone equities’ overweight view.”
While Chillingworth is certainly negative on Europe, he isn’t bearish on equities in general.
Indeed, he believes the severe market falls and elevated volatility that characterised the early stages were way overblown and therefore is overweight equities in general across his firm’s portfolios.
“Stock markets posted sharp declines at the start of the year owing to anxiety about the state of the world economy and fears of a recession. Yet the underlying economic data for developed markets suggest investors overreacted,” he said.
“We believe the latest bout of market turbulence is due to fear rather than fundamentals and sentiment has already improved. Despite a number of concerns in the global economy, we do not believe a more defensive stance is warranted.”
For example, Chillingworth is bullish on US equities – despite many of his peers believing it to be an area of the market to be richly valued.
FE data shows the S&P 500 has been the best performing major equity index since the global financial crisis, having posted positive gains in each of the past seven years. It also fell less than the most other markets during the crash of 2008.
Performance of indices since 2009
Source: FE Analytics
However, Chillingworth says the rally in US equities still has legs.
“US equities remain a core overweight. Following weak economic data at the start of 2016, there has been concern that the US could fall into recession this year. Yet its economy appears to be robust at the moment with particular strength from consumer spending as well as the jobs market,” Chillingworth said.
“Although recent data have been lacklustre, the US economy is growing at an annualised rate of around 2 per cent. Low oil prices have benefited lower-paid workers, and consumer spending and employment conditions remain buoyant.”
“Markets are likely to become more sensitive to news surrounding this year’s presidential election, which appears to be heading to a two-way race between Hillary Clinton and Donald Trump. US earnings fell by around 3.5 per cent in the fourth quarter of 2015 compared with the same period in 2014 owing to weak commodity prices and dollar strength. If the outlook does not improve when companies release first-quarter results, talk of an earnings recession may gain traction.”
“Yet we continue to like the US stock market. Although valuations are not cheap, it continues to provide a rich source of investment opportunities.”
