The case for raising interest rates in Europe remains strong and shouldn’t be viewed with caution by investors, according to Artemis’ Paul Casson.
The manager of the five FE Crown-rated Artemis Pan-European Absolute Return fund said he has begun to position for higher rates after years of low rates following the global financial crisis.
“In some respects, investors have had it easy for the past few years,” said Casson. “The combination of improving growth, limited inflation, low interest rates and quantitative easing has had a soporific effect.
“Markets went up, valuations became ever more expensive and nobody worried too much about how or when things might change. But they have changed.”
Casson said interest rates were not high enough for the current level of economic growth in Europe, which – while good news in the medium term – might spook short-term investors.
He said higher rates could cause an upset in markets in the short term, as popular momentum-based strategies that work best when rates are falling would need to be unwound.
The case for hikes by the European Central Bank is strong after years of the low-rate environment and stronger growth in the global economy.
Inflation in the EU28 since start of data
Source: Eurostat
“Demand for both manufacturing and services is strengthening across Europe,” said Casson. “Investment, which has been depressed for years, is coming back. Even Spain, which has endured recession and high unemployment, is willing to spend again to meet demand.
“As a result, forecasts for GDP growth have been raised steadily throughout 2017. Interest rates are sensitive to this and will react.”
Another reason that rates must rise, according to Cason, is the prospect of a future recession where central bankers will need to cut interest rates in response.
“As there is barely anything to cut, that cannot be done from here,” he explained. “So rates must rise first.”
Casson also highlighted reduced levels of bond purchases via the quantitative easing programmes and the need to introduce an incentive for new buyers through rate hikes.
Perhaps the most important element for interest rate rises, however, is the return of inflation, said the Artemis Pan-European Absolute Return manager.
Labour shortages are likely to lead to wage rises and companies passing on the costs by increasing prices, Casson explained, “the inflationary consequences should be clear”.
“In the past, markets were worried that central bankers would be too late to raise interest rates in the face of higher inflation and so would need to lift them more quickly to compensate,” the Artemis manager noted.
“Inevitably, this would provoke the next recession. Central bankers have not forgotten this risk is another reason interest rates must rise.”
As such, Casson has taken several steps to help prepare the long/short equity strategy for the impact of rate hikes. The manager said while higher rates might see a fall in equity valuations, the growing global economy will ensure that some companies continue to benefit.
“Businesses that sell more in periods of economic growth can offset the pressure on their valuations by increasing their earnings,” he said. “Typically, these tend to be in cyclical, economically-sensitive sectors. And they also offer value.
“After years of tepid growth in earnings, many domestic cyclical stocks and banks are cheap, seemingly in the expectation that the future will be the same as the recent past. This is not necessarily the case.”
The Artemis Pan-European Absolute Return fund noted: “As demand increases, pricing power improves. We like the combination of attractive valuations and potential for upgrades to earnings.”
Casson said companies that do not see much change in demand for products when growth is strong will have nothing to offset against higher interest rates.
EU28 GDP growth since start of data
Source: Eurostat
“Many of these stocks also look expensive, making them vulnerable to higher interest rates and inflation,” he explained. “Of course, the current situation is not the same as the past. We are emerging from a period of unprecedented intervention in financial markets by central banks.”
The manager said under such conditions it might be best to avoid areas such as utilities, consumer staples and healthcare in favour of companies in the financials, materials and energy sectors.
“We confess to not knowing what to do about technology: expectations for future earnings growth are very optimistic – and valuations are high,” he added.
Casson said the recent sell-off in markets disguised a rotation into more economically sensitive areas that will be supported by improving earnings. It had also been indiscriminate with sell-offs across all asset classes, even ‘safer’ government bonds.
“This is quite different to the pattern of the last few years where every shock sent more investors towards government bonds,” he said. “In our view, this is further evidence that a change in market regime is happening and that the forces depressing interest rates are abating.
“The scale and speed of the recent correction was significant, no doubt exacerbated by machine trading and passive flows.”
Casson said during corrections, the manager relies on the Artemis Pan-European Absolute Return fund’s short book to reduce its exposure to market falls.
“As investors panic, short positions often hit our price targets for different reasons to the ones we envisioned,” he explained. “We have taken advantage of this to close shorts in consumer staples, telecoms and industrials and reduced positions in support services.”
He added: “One frustration we have had in the past couple of years has been the unwillingness of the market to punish weak companies and those with too much debt.
“Our sense is that this is beginning to change so we maintain short exposures to those stocks.”
Casson said the combined effect of tactical short closing and adding in other areas had been a reduction in the short book, while it has also taken advantage of the oversold conditions to add to existing holdings.
“What we are seeing in markets is the unwinding of excessive leverage predicated on low volatility and interest rates,” said Casson. “This is healthy and the result should be more considered and differentiated investment activity – something we hope to take advantage of in both the long and the short books.”
Performance of fund vs sector & benchmark over 3yrs
Source: FE Analytics
Over three years, the Artemis Pan-European Absolute Return fund has delivered a total return of 22.42 per cent compared with a 5.86 per cent gain for the average IA Targeted Absolute Return fund, although it should be noted that the sector is home to a range of different strategies.
The fund has an ongoing charges figure (OCF) of 0.93 per cent.