Value funds are the best way to invest in Europe as inflows and positive economic data appear to have peaked, according to Rathbones’ Mona Shah.
Europe has been a popular sector this year, with investors buoyed by political outcomes that were viewed as market positive as well as strong economic data and robust corporate earnings from the region.
As such, over the last year the MSCI Europe ex UK has outperformed the broader developed world index, the MSCI World, by 5.34 percentage points, as the below chart shows.
Performance of indices over 1yr
Source: FE Analytics
“We have seen an almighty rally in Europe in the second half of this year and this has been to do with improving economic indicators,” Shah said.
“There has certainly been momentum in the economies this year which has been great and I think also some fears regarding the political environment have been calmed following Emmanuel Macron and Angela Merkel’s [election victories].
While this momentum has been a positive for the region, the Rathbones head of collectives research said investors should not expect this to continue.
“In terms of mainstream Europe our indicators suggest that growth peaked in the second quarter and in fact the Belgian Business Confidence survey – our favourite indicator – has been suggesting deceleration,” she said.
Part of this is due to the banking system, which is still failing to lend to more domestic-focused businesses particularly in peripheral Europe. “You are still seeing a hangover of bad debt from the debt crisis,” Shah said.
Additionally, much-needed labour reforms have been slow to take off with Spain the only major economy to bite the bullet and make sweeping changes.
“The only one that we have seen go through considerable reforms and deliver has been Spain. We have seen some interesting labour market reforms come through there,” she said.
“Broadly, apart from Spain, we still feel there is slack in the labour market meaning wage pressure is weak and long-term unemployment is still high,” said Shah. “You might see a bit of pressure on higher skilled wages but downward pressure on lower skilled wages, typically that pattern isn’t great for GDP growth.”
Despite this, she said, investors can find areas to invest in but must look further afield than the expensive growth and defensive stocks, which have been the main beneficiaries of this year’s rally.
“We have seen giant flows from the passive space into Europe and we have seen money coming out of the US,” she said.
“We are still seeing flows going Europe but they have come down quite markedly from where they were at their peaks, so I think that is quite an interesting indicator for putting money to work in Europe today. You probably don’t have the momentum behind you anymore.”
As such, the large-cap companies on high price-to-earnings multiples are the most likely to come under pressure.
However, while some managers are avoiding the area entirely due to the recent rally, Shah said there are pockets of value for investors willing to take on higher volatility.
She suggested investors look to more value-orientated strategies, but warned that much of the value sector centres around banking stocks.
“Value in Europe is full of banks and insurers and looking at that sector when you compare US banks to European banks, the US banks have really cleaned things up a lot,” Shah said.
“Some people I talk to say the peak of the regulation burden is behind them in the US and from here they expect interest rates to go up and the US banks to really benefit from that.
“Whereas in Europe we are still not there yet, we are still cleaning up and still seeing them being hit by regulation and we still have concerns about the loan quality on bank books in Europe.”
Investors that have taken a passive approach to Europe however will be taking a bigger bet than those with an active allocation.
The Euro Stoxx index for example is 22 per cent weighted to financials with about half in banks, while the Euro Stoxx Large Cap Value index is 50 per cent financials.
“That is massive so you can see that you really do have to take a big financials bet and I am not sure if all investors are seeing the scale of that,” Shah said.
As well as this, the economies are more sensitive to the banking sector than many may expect, with 23 per cent of eurozone returns explained by banks.
And when you look at peripheral Europe like Greece, Italy and Spain you are up at around 40 per cent, Shah added, noting that analysts’ consensus earnings per share growth for 2017 is “only 7 per cent”, much lower than the market average.
“The key to the value trade is very much centred around financials and things are still difficult there so most of the European fund managers on our recommended list are not overweight financials,” she said.
As there are no sector anomalies or wide dispersions within the market, Shah noted that “unless you have a long-term time horizon and a big appetite for volatility buying Europe today is hard”, although there are some funds on its recommended list.
The best value-focused fund she said is the five FE Crown-rated CRUX European Special Situations run by FE Alpha Manager Richard Pease and James Milne.
“We really like Richard Pease at CRUX. His portfolio philosophically is (and in terms of the way it is composed looks) really different to [growth funds such as] Alexander Darwal’s Jupiter European fund which is much more about owning the top global market leaders.”
Performance of fund vs sector and benchmark over 5yrs
Source: FE Analytics
The £1.9bn fund has been a top quartile performer in the IA Europe ex UK sector over three and five-year periods, returning 119.22 per cent in the last half-decade, as the above graph shows.
CRUX European Special Situations has a yield of 1.45 per cent and a clean ongoing charges figure of 0.87 per cent.