The financial crisis and the measures promoted by European central banks have resulted in a much-changed investment environment, according to Schroders head of UK and European equities Rory Bateman.
The consequences of these measures were mainly seen in equity markets, as, for a number of years, investors piled into sectors offering stable dividend streams – so-called ‘bond proxies’ – due to the low yield environment.
But as central banks begin withdrawing quantitative easing and interest rates start to normalise, stock-specific themes are expected to become the main driver of share prices, said Bateman.
“We believe we may be entering an era of lower stock correlations as the period of extremely loose monetary policy draws to a close and macro themes become less influential in determining individual share prices,” he noted.
“Given the unwind in market correlations, bottom-up fundamental analysis is likely to become more important than ever when identifying the successful companies that will generate alpha.”
Source: Schroders
In order to find the winning companies, it is vital that investors understand the changes markets have undergone since the depth of the global financial crisis.
“Our analysis suggests many industries and companies have transformed themselves during the post-crisis era with the intention of building their resilience should there be a repeat of the global financial crisis in the years ahead,” said Bateman.
“It has become very clear that the outstanding companies of tomorrow are those that have learned and adjusted their business models since the crises.”
Below, Bateman considers the main changes some key sectors have undergone since the onset of the crisis.
The crisis has had an impact across the European market most notably in the financial sector, which was directly implicated. As Bateman noted, the excessive risk-taking by banks during those years has led to an emphasis on regulation, capital strength and improved disclosure.
Such changes are evident by banks’ disclosure of their Core Tier 1 Capital – the amount of capital the bank holds to absorb losses before other investors experience losses, which should never be less than 6 per cent.
“Incredibly, back in 2007 Royal Bank of Scotland would not even disclose its Core Tier 1 capital ratio, which was subsequently revealed to be 4 per cent,” he said.
“RBS now boasts a 15.5 per cent Core Tier 1 ratio whilst the broader pan-European sector averages around 14 per cent. The way in which this capital is calculated has also changed, a positive move “to ensure history does not repeat itself”.
Pan-European banks core Tier 1 ratios evolution since the GFC
Source: Schroders
Insurance companies, which in some cases took losses on bank subordinated debt, have also seen the implementation of a new regulatory capital standard, Solvency II. The new rules revealed strong capital positions by the insurance sector, which is currently the highest yielding sector.
Elsewhere in other sectors such as aerospace and autos, loose credit conditions as a result of low interest rates increased demand for aircraft and automobiles. However, that may now be jeopardised by tightening credit conditions and any potential fall-off in demand.
“Global airline passenger growth has averaged 3-4 per cent over the past 30 years, but it must be noted the airline industry is hugely cyclical,” said Bateman.
“It will take only a marginal slowdown in passenger growth to tip the market into excess capacity, knocking ticket prices and hurting profitability.
“If that occurs alongside a tightening of credit, then the aerospace industry will see order cancellations,” Bateman pointed out.
The automobile sector also benefited from the supply of cheap credit through loose monetary policy, a fact that has helped support very low lease rates, encouraging customers to pay higher average selling prices, Bateman noted.
The post-crisis environment has also been challenging for defensive sectors such as the telecommunications and utilities sector, with the latter still recovering from its pre-crisis M&A boom.
“Borrowing remains high across the sector and dividends are barely covered by cash flows, leaving many utilities exposed to regulatory and political risk,” explained Schroders’ Bateman.
“Since 1995, the three top-performing European utilities have on average outperformed the bottom three and the market by 60 per cent and 40 per cent respectively.
“This is a proof these liquid, volatile stocks with divergent regulatory, political, and commodity drivers can be a source of idiosyncratic returns.”
He also noted that the telecoms sector has been the worst performer over the last ten years, with the only beneficiaries from this sector being consumers, as prices have reduced on an absolute basis and quality of service has improved.
“The large telecom companies were cash generating machines until 2012/13 when the first wave of huge investment was required – 4G,” he said. “Since then they haven’t stopped investing – 4G+, fibre, 5G – roughly doubling capex while revenues and profits went into reverse.”
Indeed, since the crisis started the FTSE World Europe ex UK index has risen by 14.46 per cent compared with a 28.97 per cent loss by the FTSE World Europe ex UK Telecommunications sector, as the below chart shows.
Performance of telecoms sector since 2007
Source: FE Analytics
As other sectors have had to deal with more direct fall-out from the crisis other sectors have been less affected. Indeed, the importance of technology in everyday life has become a dominant trend in the decade since the crisis began.
“The consumer sector has so far seen the greatest impact of this as we order everything from clothes to food to taxis online,” said Bateman. “The next wave of change could come in industrial businesses as these increasingly embed new technologies in their operations.
“The benefits for those that have embraced technological change are widespread, while the risk to those that haven’t will only continue to become more acute. We expect stock performance to differ accordingly.”
Bateman said the ultra-low interest rates have encouraged risk-taking by insurgents, adding: “New, disruptive companies can obtain very low-cost finance that allows them to expand quickly and take on incumbents, who often have high fixed costs that make them less agile.”
Summing up, Bateman said: “Just as companies had to adapt in order to survive in the immediate post-global financial crisis era, so they will need to change again in order to succeed as monetary policies start to normalise.
“Those companies that have strengthened their balance sheets, reduced their costs, engaged all stakeholders, and embraced technological changes are likely to find themselves better-placed than those who have not.”
He added: “This may be a challenge for corporates but it opens a clear opportunity for stockpickers like ourselves as we expect clear distance to emerge between the winners and losers in this new investment landscape.”