Brexit is more likely to result in a tick-up in European markets than it will in a “domino effect” style collapse of the European Union, according to Liontrust’s Olly Russ (pictured). 
The manager, who runs Liontrust European Income (formerly FP Argonaut European Income), says there are other headwinds facing the region that investors should be aware of, although generally speaking he is positive in terms of finding investment opportunities.
Europe has dominated financial headlines recently due to heightened political risk in the region – in addition to Brexit, there is a constitutional referendum in Italy in October and general elections next year in Germany, the Netherlands and France.
Not only this, the current banking crisis in Italy, concerns regarding immigration and the recent string of terror attacks have thrust the region back into the limelight.
Predictably, this combination of events has impacted the MSCI Europe ex UK index year-to-date, which has underperformed most other major indices in 2016 so far.
Performance of indices in 2016
Source: FE Analytics
Russ says this presents a strong bull case for Europe at the moment as it means that valuations are particularly attractive compared to government bonds, corporate bonds and other equity markets.
“The European market is not over-owned in any way, shape or form, so there are a lot of companies with good yields over there,” he said.
“I also think the domestic European economy is recovering quite nicely at the moment having been in the doldrums for many years, so there is a very positive case to be made for Europe. It’s just that the experiences over the last few years have made us very much focus on what could go wrong rather than what could go right.”
“Barring any further disasters, I think Europe is on a recovering trend and that will drive things like domestic sales, domestic growth and auto sales, as Europe really plays catch up. European earnings are still a third below their peak as opposed to the US which has hit all-time highs, so Europe is under-earning relative to its traditional history at a time when the economy is becoming more positive.”
Not everybody agrees with this sentiment though and some remain wary on the seemingly troubled region.
FE Alpha Manager David Coombs, who heads up the multi-asset portfolios at Rathbones, told FE Trustnet that he purposefully has very little exposure to the eurozone at all at the moment.
“People keep telling me that Europe is cheap but I think it’s a massive value trap. I think the risk of contagion effect risk following on from Brexit is quite high and there’s a lot of political instability coming up in Europe,” he warned.
“I think Brexit has given the whole notion of leaving the EU credibility. Despite what people say there were a lot of normal people who voted Brexit, they weren’t all extremists.”
“I think there is huge political instability in Europe and most of the European stocks I own are outside of the eurozone and are global earners.”
Following the announcement that the UK was to undergo an EU referendum, French National Front leader Marine Le Pen and far-right Dutch politician Geert Wilders have demanded similar referendums in their own countries.
However, Russ disagrees that there is a contagion risk regarding other regions leaving the EU and argues that it is a different story when it comes to members of the eurozone leaving Europe.
“For Europe itself, I don’t think [Brexit] makes a lot of difference - to be honest, you might actually see a slight tick up in investments from investors who had earmarked the UK and might go into continental Europe instead,” he reasoned.
“But by and large, I don’t think it’s going to make much of a difference. It’s not going to spark a huge domino effect of similar referendums with everyone clambering to get out of Europe. The evidence so far is in fact that appetite to leave Europe has declined in most countries.”
“Not forgetting that most of these countries are in the eurozone and I think it makes very little difference to the UK whether it is or isn’t in the eurozone, which is basically a customs union and not a free trade area.”
The manager says that the UK’s “escape valve” when it comes to Brexit repercussions has very much been its currency, whereas if a member of the eurozone were to leave the EU, they would have to leave the euro as well.
He argues that this is a very different proposition because, despite the fact that UK and European shares initially tumbled after the referendum results were announced, there has since been a strong bounce back and he adds that bond markets barely reacted at all.
Performance of indices over 1month
Source: FE Analytics
“It’s not a financial crisis but it is a political crisis. If the eurozone countries were to leave, then you would have a financial crisis because we don’t even know how it is possible to get out of the eurozone,” Russ continued.
“For the UK to leave the EU is actually relatively simple compared to a eurozone country trying to get out. It’s just not clear how that would work and that would be a financial crisis, therefore I don’t think any eurozone country is in a position to attempt that.”
The biggest problem facing Europe at the moment, according to the manager, is the Italian banking sector and the way in which it will be dealt with by its government.
Following the region’s torrid combination of bad debt build-up, falling property prices and slowing growth, the eurosceptic Five Star Movement party has become a more prominent feature of Italy’s political landscape and is currently campaigning for a referendum to leave the euro.
“This is far more significant than Brexit for the eurozone: the Italian referendum is coming up in October. Prime minister Renzi has said he will resign if it doesn’t go in his favour, which could create a political vacuum at the same time as a banking crisis which is exactly what we don’t need,” he warned.
“What we need to see is the banking crisis fixed first before we go into this referendum. The Five Star Movement is of course anti-euro and they’re quite right in a way to diagnose that Italy does have economic problems, but their solution perhaps is not right.”
“What it requires is for productivity in Italy to improve, that’s what’s causing the economic damage, that’s what’s causing the problems in the banking sector really.”
“Now Renzi’s reforms will go some way to address that and make reforms possible. I think the German view, and I have a lot of sympathy with it, is that the eurozone is what you make of it really because 20-odd years ago Germany was regarded as the sick man of Europe.”
Russ said that the now-economic powerhouse underwent a series of gruelling structural reforms which included keeping wages virtually flat for decades in order to strengthen the German economy.
In contrast, he says that wages in Italy have continued to increase but the country can’t devalue its currency to improve competitiveness, given it’s in the eurozone. He explains that this has placed a further strain on Italy’s productivity.
“That’s their key problem and being in the euro they can’t devalue their way out of trouble and haven’t really adjusted to that, that’s what the need to do,” Russ explained.
“The euro is exacerbating the problem but the solution lies in their own hands – they should have reformed and restructured a good 10 years ago.”
Since Russ launched the fund in 2005, Liontrust European Income has returned 96.04 per cent, which is broadly in line with its sector average and an outperformance of its benchmark of 14.9 percentage points.
Performance of fund vs sector and benchmark since launch
Source: FE Analytics
In terms of its risk metrics, the fund has achieved a top-quartile annualised volatility and maximum drawdown (which measures the most potential money lost if bought and sold at the worst times) over the same time frame.
