Europe – Looking for the truth behind the indices

Chief Investment Officer Pierre-Henri Flamand gives his take on the latest political developments in Europe and explains why it is important in his view to make a distinction between indices and economic regions they purport to reflect.

Now, with a little perspective, it’s possible to perceive more clearly the elements that combined to destabilise markets at the end of January. At the time, the most widely-held explanation was the fear that positive U.S. jobs numbers might accelerate the pace of Fed rate rises. This was certainly a factor, but there was something else troubling observers: the threat of a currency war that appeared to arise in the back-and-forth posturing of Steve Mnuchin and Mario Draghi at the time of the Davos meeting. In a clear move away from what has become known as the Shanghai Agreement, Mnuchin chose to talk down the dollar in his speech to the World Economic Forum. Draghi hit back the next day, lamenting “the use of language ... that doesn't reflect the terms of reference we have agreed". While not comparable to the very sharp declines of early February, equity markets took another hit at the end of the month after Trump’s protectionist statements about import tariffs on steel and aluminum. It looks as if we can now add trade wars to currency wars in terms of clouds on the horizon.

All of this has meant that our relative bullishness on Europe has been held up for closer scrutiny more than ever. The European markets remain closely linked to the performance of the euro, and the prospect of the U.S. taking steps to depress the dollar have led to underwhelming performance in the European indices in the year to date. The FTSE 100 is down almost 7%, while the DAX is down over 5%. You might think we’d be rowing shamefacedly back in our Europhilia at this point, but our European funds have all had an encouraging start to the year, whether that be in our long-short or long-only strategies. Rather, what this latest bout of market volatility has seemed to do is refine the terminology of our position, and to make us think more philosophically about what we mean when we say that we are positive about one or other geographical region.

It may be stating the obvious, but indices are a far from perfect representation of the state of their underlying economies. They are necessarily a composite of companies constructed according to a certain set of rules; the recent underperformance has brought home to us the striking difference between the type of firms that make up the indices in Europe and those in the U.S. In Europe, the indices are comprised of largely old-economy companies. As shown below, 56% of the market cap of the S&P 500 is comprised of companies that were incorporated after 1981, whereas the equivalent number for Germany’s DAX 30 and Frances CAC 40 are only 33% and 32% respectively. Europe also tends to host many more regulated industries within its indices and there are fewer fast-growing tech stocks. In short, it’s hard to imagine a firm within a European index that is changing the world.

Figure 1. European indices are more ‘aged’ compared to the US

Source: Man Group, Godman Sachs, 9 March 2018.

While it may therefore initially appear more difficult to invest in Europe, we believe that there is potentially more to gain by those prepared to do the work. You have to recognise the demands posed across numerous regions and languages, to comprehend the nuances and allusions of management teams in different cultures. There are higher barriers to entry when investing in Europe: you need to have a large and diversified team, and one that is highly skilled in the fundamental analysis that is needed to try and uncover the opportunities that exist within the European markets.

So while we don’t believe just taking blind exposure to Europe is a good strategy, we would argue that, through active management twinned with extensive research, there’s potential to achieve compelling returns in these markets. Given recent price movements, we believe it’s now worth looking within the European indices to see whether there are firms that may have been dragged down because of their proximity to less well-run businesses. The DAX is currently trading at 11.7x 2019E earnings according to Bloomberg when compared to 15.8x for the S&P 500. There are a number of companies within the DAX that are cash-generative, with real assets and compellingly entrenched business positions. They certainly merit further inspection, in our view, particularly since we believe that the economic and political backdrop for Europe looks more positive than might be supposed given negative press reports.

Figure 2. 2019 Forward P/E ratios for selected markets

Source: Bloomberg, as of 8 March 2018.

We wrote last year – prior to the German elections – that it might be preferable to have Martin Schulz and the SPD (Social Democratic Party of Germany) in power, with their fierce commitment to the European project, than an Angela Merkel (perhaps bolstered by support from the right) who appeared increasingly disenchanted with Germany’s role in Europe. As it turned out, we ended up getting the best of both worlds, with Merkel’s economic liberalism twinned with the pro-European stance of coalition partners, the SPD. We now have a situation where the two leading Eurozone economies are led by Europhiles committed to the continuation of the project of Continent-wide integration. At least for the next five years, we cannot envisage a return to the days of 2009-11, when the failure of the currency and the political ideology that forged it seemed a very real prospect.

It’s initially worrying to look at the vote share achieved by anti-establishment parties in the Italian elections – somewhere around 60%. There are clearly some very unhappy people in Italy, although we’d suggest that immigration rather than Europe is the central bone of contention. Even this, though, may end up being positive for Europe more broadly, at least in the medium term. Pro-EU (European Union) northern European states will hopefully recognise that there is currently a groundswell of negative sentiment in Southern Europe and that they need to spend to counteract this. Reflationary investment – either through infrastructure or social spending (or both) – may serve to remind disgruntled Italians (and Spaniards and Greeks) that there are notable benefits to membership of the world’s largest trading bloc. Indeed, if Trump follows through on some of his more drastic protectionist notions, inside the EU might end up feeling like the safest place to be. We believe that the ECB (European Central Bank) will continue to be patient when it comes to raising interest rates – necessarily far more so, in our view than the Fed. Crucially, this could keep the euro from appreciating dramatically, notwithstanding inflationary pressures that may start to emerge. Whatever the case, we remain convinced that those with the expertise to uncover them may continue to find potential opportunities within a Europe whose key leaders remain more committed than ever to the integrity of the single market and currency.