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Bennett: Inflation in Europe a "game changer" for value managers

01 March 2017

Henderson’s John Bennett explains why Europe could beat the US this year and why value looks set to outperform providing interest rates remain stationary.

By Jonathan Jones,

Reporter, FE Trustnet

Europe is the best market globally to find value and has the potential to outperform the US this year, according to John Bennett, manager of the Henderson European Focus Trust

The value style has underperformed over the last decade, particularly in Europe where value stocks have returned just 29.70 per cent over the last 10 years compared with returns of 111.75 per cent from growth stocks.

“If you just take so-called quality – which is high return on capital and low volatility on earnings-type businesses – relative to the rest of the market you can see that save for the ‘dash to trash’ of 2009 you’ve had a one-way street in favour of growth, low volatility and quality,” Bennett (pictured) said.

“The performance of high quality stocks has been especially strong in Europe since 2009 because that’s the very quality, the very characteristic that has been missing and scarce – growth.”

Performance of indices over 10yrs

 

Source: FE Analytics

However, last year value stocks outperformed growth stocks for the first time since 2013 and only the second year since 2009 and as a result, Bennett has moved his portfolio into the value area.

“We’ve tilted the trust – as we have all of our portfolios – to value away from growth and that actually started with a very tentative tiptoe into oil in September 2015. But we got more aggressive with that move to so-called value and away from so-called growth in particular in the second half of last year,” he said.

“The big poster child sector for what was once value and became an optical illusion of value for about a decade was banks and we even bought those in the second half of last year.”

But for this to work, he concedes, a lot of things have to go right, or “not go wrong”, in Europe.

The first is that valuations of the high growth European stocks begin to come back down from their 10-year highs, with more investors looking to other areas of the market.


As the below graph shows, Europe is at the top of the cumulative relative monthly performance of high quality stocks over the last 10 years, compared to America, Japan and Asia.

Cumulative relative monthly performance of high quality stocks from 2008 to 2016

 

Source: Henderson

“It’s where you’ve wanted to be,” Bennett said as “if something is scarce you bid it up in price”.

Indeed, the valuation premium of high quality growth in Europe is currently high relative to its own history reaching the 99th percentile, according to the manager, while Japan has risen to the 96th percentile.

Meanwhile, the US is at just the 21st percentile. Bennett added: “In my view that is because America had growth so why would you bid up and stretch the premium for growth stocks to the same extent when growth is more widely available.

“The relative multiple of high quality European stocks vs their US counterparts is also high relative to its own history up into the 94th percentile.”

As such, he says in recent years people who bought European stocks and funds didn’t actually buy Europe, they bought high quality global-proxy stocks and bond-proxies who happened to be based and listed in Europe.

However, he says the world has moved from a growth to a value market and, if this is correct, then value markets of the world such as Europe and Japan should outperform.

“If we are right in that then it should mean that for once Europe and Japan outperform the S&P 500,” he said.

“In 2016 some would say Brexit was the catalyst some would say Trump was the catalyst, it actually started before then - value outperformed growth and our call is that is going to continue.”


While the trust struggled in 2016, returning just 4.05 per cent against the 19.69 per cent return of its FTSE World Europe benchmark, so far this year the fund is up 10.88 per cent, significantly ahead of the 2.76 per cent return from the benchmark.

Performance of fund vs sector and benchmark since Jan 2016

 

Source: FE Analytics

However, for this recent outperformance to continue, Bennett says there is one key factor that needs to hold true – interest rates are going to stay level.

“There’s almost nothing else you need to know in my view to answer the question will value continue to outperform growth,” he said.

“If this fails i.e. bond yields roll over and we go back to negative yields in the likes of bunds etc. it knocks value on the head and certainly the banks on the head.”

The manager says bond yields, which have been rising for the last few months on the back of higher inflation expectations in Europe, are the key to value – and particular banks – outperforming.

“The biggest delta in inflation surprise came from the eurozone. Not because the eurozone is a hotbed of mad rampant inflation, just because inflation expectations were face down in the ditch,” he said.

“No one really expected that Europe would grow, let alone have some inflation come in and Germany has had a CPI print of 1.9.

“That is wholly inconsistent with negative bond yields and I think we have a game changer on our hands in terms of even a modest rise in inflation expectations because I think what has gone on in the bond market is madness.”

He says that if this reverses and Europe looks set to go back to a negative inflationary state, investors do not want to be in the Henderson European Focus Trust, but adds that “our business is about being on the right side of surprise”.

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