Rising inflation and stronger economic growth are beginning to have a positive impact on valuations in the European market with more robust yields, according to Invesco Perpetual’s Stephanie Butcher.
The fund manager of the four crown-rated Invesco Perpetual European Equity Income fund said that economic indicators in the region have strengthened more recently while valuations in the region look more attractive. Markets have performed more strongly recently as sentiment towards the region has improved. The MSCI Europe ex UK index was up by 38.27 per cent in the 12 months to 19 May 2017, compared with a 28.3 per cent rise in the FTSE 100 index.
Performance of FTSE Europe ex-UK over 1yr
Source: FE Analytics
Butcher said: “We felt that the European equity market has been good value for a number of years. But one of the issues with valuation is finding a catalyst to release that valuation.
“At the moment, for the first time in a number of years, we have a combination of cheap valuation but with the economy recovering, earnings recovering, inflation turning more positive and still international investors are underweight the region. I think that is quite a powerful combination.
“For global investors, for the first time, Europe is quite high up on the priority list and that will have ramifications for performance going forward.”
She noted that European corporates had benefited from “significant improvements” in economic growth and rising inflation in the region, following a “really consistent period of disappointment” for both indicators last year.
“That’s been important for Europe as in aggregate a region as companies are price takers rather than price makers,” she said.
“Which means if there is a period of low growth with little inflation, European corporates have to work hard to keep margins flat.
“If they can do that that is no small achievement but very difficult to get any. When we move into period of growth picking up and inflation coming through it makes life much easier for European corporates.”
Butcher noted that financials and energy stocks were the biggest drags on earnings performance during 2016 as the oil price fell and banks were at the tail-end of having to make further provisions over liquidity.
“We start to see evidence of earnings picking up from very low base,” she said. “We should be able to see quite comfortable earnings growth.”
Despite more positive signs emerging, European equities remain undervalued. The fund manager said equity risk premium remains higher than US equities.
She said: “Although we’ve come off the top, we are nowhere near more normalised levels. When we look at the analysis of what drives that, one word has dominated: politics.”
The fund manager said concerns over the rise of populism and elections in several key EU states have been allayed more recently following the French elections and the defeat of Marine Le Pen by Emmanuel Macron.
“When we go back to good, old valuations and why would you bother coming back to Europe, put simply it’s because it’s such a cheap market,” she said.
“If you are an investor looking for yield there is only one area where you can find yield above the 30-year average and that is Europe.
“What I like about being an income investor in Europe is that yield is supported by pay-out ratios that don’t look elevated and some sectors look like they have room to go higher.
“There are also very robust corporate balance sheets; you’re not seeing European corporates taking on extra debt, not seeing stretched balance sheets.
“Therefore that yield we are looking at across a number of different sectors looks eminently sustainable.”
The manager has been positioning the fund in more unloved sectors such as oil & gas and financials sectors where valuations have been hit by a drop-off in earnings.
In the energy sector, Butcher said there are structural and cyclical reasons why earnings will recover. The sector has witnessed management changes where they have started to focus on becoming more efficient, resulting in improvements in free cashflow in the sector despite stressed oil prices.
Elsewhere, in the financials sector Butcher says yields look increasingly compelling as banks continue to move away from riskier investment banking and years of balance sheet strengthening draws to a close with more cash available for distribution.
Meanwhile, overvalued but high-yielding sectors such as consumer goods and healthcare form significant underweights in the portfolio.
“Our sense is and always has been that the best way to control risk is not to overpay for assets,” she explained.
Yet, Butcher said that the fund retains a focus on quality within the portfolio. Its largest holdings are healthcare stocks Novartis and Roche, representing over 4 per cent of the portfolio each. Banks including CaixaBank, ING, BNP Paribas and Intesa Sanpaolo are also represented in the top 10 holdings. Other names include telecommunications firm Orange, consumer goods brand Ahold Delhaize, oil& gas company Total and industrials firm Siemens.
Performance of fund vs sector & benchmark over 1yr
Source: FE Analytics
Over one year the fund is up by 40.2 per cent compared with a 34.1 per cent rise in the IA Europe ex UK sector. However, it has slightly underperformed the average sector peer’s 38.6 per cent gain over three years, rising by 38.4 per cent in comparison.
The fund has an ongoing charge figure (OCF) of 0.94 per cent and a historic yield of 3.19 per cent.