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IBOSS’ Metcalfe: Why my Europe exposure is at an all-time low

22 July 2022

Europe has overtaken China as the world’s most volatile region as uncontrollable inflation and a dependence on Russian gas create a “bleak outlook” for the market.

By Tom Aylott,

Reporter, Trustnet

Soaring interest rates and a dependence on Russian gas has turned Europe into the most volatile market to invest in, according to Chris Metcalfe, chief investment officer at IBOSS Asset Management.

The region has developed a “very sad backdrop” over recent months as the European Central Bank (ECB) is slow to pounce on rising inflation and Russian president Vladimir Putin holds the continent’s main gas supply to ransom.

Metcalfe has reduced his exposure to “the lowest European weighting we’ve probably ever had” as he braces for a long and difficult period.

He said: “Europe looks absolutely desperate going into the second half of the year. I've never known such a bleak outlook – it’s far worse than any other crises before.

“Whether Europe goes into a very deep recession or not seems to be hinging completely on whether Putin decides to turn that gas back on – that's a pretty lamentable position to have got yourself in.”

That gas supply was resumed yesterday after Europe spent the previous 10 days contemplating whether 40% of its gas would be switched back on.

Although the Nord Stream 1 pipe that funnels gas from Russia is back up and running after maintenance, it is only operating at 40% capacity.

This is enough to keep Europe going for now, but with gas reserves not high enough to last the winter, the continent is left “particularly vulnerable to whatever Putin decides to do,” according to Metcalfe.

Tom Morris, fund manager on Liontrust’s Global Fundamental Team, said that Europe would not be so dependant on gas from Russia if they had de-escalated the demand for fossil fuels at the same rate it reduced domestic supply of them.

“Many European countries had made a choice to discourage domestic oil and gas production as part of their efforts to tackle the energy transition,” he said. “The problem was that very little had been done to reduce demand for fossil fuels and this left Europe highly reliant on Russian gas imports.”

Over the past few months, Europe has reopened a number of coal power plants that had previously been closed in its move to net-zero. Even with this added boost, supplies are low and rationing may not be enough if tensions escalate and Putin shuts off the supply for good.

To make matters worse, the ECB is just at the start of its fight against inflation, with the central bank applying its first interest rate hike of 50 basis points yesterday.

Morris pointed out that “high inflation and a slowing economy were clearly visible on the horizon last year” - the Bank of England and Federal Reserve took prompt action to these warnings and began tightening their monetary policies at the end of 2021 and start of 2022 respectively.

Contrastingly, the ECB suggested high inflation was a transitory issue and distanced itself from the hawkishness of other central banks. Now that price rises look set to stay, it has ditched the plan to wait things out and has hiked up rates, but it may already be too late, according to Metcalfe.

He said: “Europe has rampant inflation that has totally gotten away from the ECB because it was in denial and had its head in the sand.”

Europe’s 8.6% inflation figure in June is still trailing behind the UK’s 9.4% rise, but the BoE hiked up rates earlier than its European counterpart. This suggests that when the UK’s inflation rate does eventually begin to recede, Europe’s inflation could continue to rise.

Metcalfe added: “To get inflation under control, it needs to raise interest rates, which is going to delve Europe into an even deeper recession. I really don’t know how the ECB squares that.

“Whatever it does from here is a mistake. It is not going to get ahead of inflation – it is just going to have to let it play out.”

Even though the ECB has now increased rates, he said that inflation figures “still look very ugly” because they have not yet fully accounted for higher energy prices.

This combination of Russian oil reliance and inflation means the region has leapfrogged China as the riskiest region in the world to invest in, according to Metcalfe.

The largest Asian market has been one of the most volatile markets to invest in for the past couple of years due to government regulation and Covid, but he said that Asia (and China) now appears more attractive than many developed markets, and he has increased exposure to the region as a result.

Charlie Dutton, manager of the Ninety One Asia Pacific Franchise fund, pointed out that China is winding down its monetary policy having already tackled inflation and brought the cost of living down.

This differs substantially from the high inflationary environment that Europe is facing and gives Chinese equities a unique selling point.

China’s swift and early action against inflation shocked international investors at first and led to a massive downturn in Chinese equities. At the same time, ‘common prosperity’ measures capped the profits on many large companies

However, the nation is now reaping the rewards of these policies and the government’s firmness in delivering its goals is an attractive trait, especially compared to the bureaucracy of the EU, according to Dutton.

He said: “When China wants to get something done, it will get it done – there's no messing around. If it has a goal, they’ll do it and everyone just has to move out the way.”

Metcalfe agreed, saying that although unforeseen changes can be painful in the short-term, the rapid execution of new policies is an appealing prospect for investing in China.

“China made six changes out of nowhere all in one night. No one else can do that,” he said. “Can you imagine the EU trying to get that amount of bipartisan support? Maybe if aliens landed we might all join together but I can’t think of much else. China has that ability to put things in place really quickly and get stuff done, whether it is good or bad.”

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