Europe, Where The Winners Took It All

Europe, Where The Winners Took It All

In 2021, the concentration of returns in a small number of winners made European equities extremely challenging for active investors (Figure 1). Although the market environment in 2022 was in many ways different from 2021, we saw the headwind of return concentration persist and even intensify.

From a hit-rate perspective, only 42% of constituents outperformed the MSCI Europe Index in 2021, which was at that point the lowest level since the financial crisis. In 2022, however, the measure fell to a new record low of 36%, extending the downward trend we have observed since 2020.

Looking at the return concentration by sector, the picture remains gloomy (Figure 2). While more than half of the 11 GICS sectors outperformed the MSCI Europe during 2022, energy meaningfully exceeded all other sectors and was the only sector within which more than half of the constituents beat the benchmark. Active managers who tend to evaluate stock attractiveness on a sector-relative basis have found stock selection difficult in sectors where very few names outperformed the benchmark.

This defies a trend we observe elsewhere in global equities. For developed markets in aggregate, about half of the MSCI World Index constituents outperformed in 2022, continuing the upward trend since the percentage of constituents outperforming hit its lowest level in 2020. In emerging markets, we saw stock returns became moderately more concentrated in 2022 – with about 48% of names outperforming – but it was far less extreme than in Europe.

Figure 1. Percentage of MSCI Europe Constituents Outperforming MSCI Europe (Cap-weighted) Index, 2007-2022

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Source: Man Numeric and MSCI; as of 31 December 2022.

Figure 2. Percentage of Constituents Outperforming MSCI Europe (Cap-weighted) Index Within Sectors, 2022

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Source: Man Numeric and MSCI; as of 31 December 2022.

Figure 3. Percentage of MSCI World & EM Index Constituents Outperforming Their Respective (Cap-weighted) Index

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Source: Man Numeric and MSCI; as of 31 December 2022.

Cannibalism or Ostracism? Japanese Autos and the Inflation Reduction Act

The auto industry is undergoing its biggest transformation in decades with a shift to fully electric vehicles (‘EV’). Unfortunately, Japanese car makers – once a consumer darling and pioneer in hybrid EV – have been slow to get the memo. Indeed, no Japanese carmaker makes the top-20 list of global EV makers by cars sold, according to Bloomberg Intelligence.¹

Japanese automakers have not had to worry much about the US as EV penetration has been relatively low up to now, with the latest figures showing just 5.8% of new car sales were EV in 2022.² However, one of the main aims of the Inflation Reduction Act (‘IRA’) of 2022 is to reduce carbon emissions by 40% by 2030; in a nutshell, both governments and environmental agencies are pushing for electrification. For Japanese automakers, we believe this would have significant repercussions: in 2021, six Japanese automakers had about 40% of the US market for passenger vehicles, according to Bloomberg data. Figure 4 illustrates the immediate effect of the IRA on Japanese automakers’ share prices, and furthermore indicates that this was not purely a currency phenomenon. Additionally, Europe’s version of the IRA is expected to be stricter than the US.

Japanese automakers have long argued that hybrids and plug-in hybrids are a better medium-term solution than fully EV when considering the shortages of battery materials, lack of charging infrastructure and carbon-intensive power grids in many countries. However, in our opinion, one of the reasons Japan’s automakers have been reluctant to electrify their fleet could be because of the importance of the auto industry locally: the sector has been a historical centre of excellence and accounts for almost 20% of manufacturing and 8% of employment.³ A pivot to all-electric would not only have an impact on Japanese auto-parts suppliers and subcontractors, but may also cannibalise current vehicle sales.

Over recent years, we have seen investors fall out of love with traditional automakers, as the market worried about how the industry would cope with a fully electric future. With every new policy created, it seems authorities are attempting to make that future happen sooner. Now that the Japanese automakers recognise this, investors will have to judge how well they can catch up, so going forward we believe it will be especially important to invest selectively.

Figure 4. Relative Performance of Japanese Automakers Before and After IRA

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Source: Bloomberg; as of 31 December 2022. The financial instruments mentioned are for reference purposes only. The content of this material should not be construed as a recommendation for their purchase or sale.

Vim, Diesel, and the Fast and Furious Gas Substitution

We noted last week that Europe managed to avoid the usual December drawdown on its gas storage in 2022. As well as demand destruction from a milder winter, one factor has been a switch from natural gas to diesel by some industrial users. Anecdotally, we are aware of one glass manufacturer that moved from being 100% gas fired to being close to a peak of 40% diesel fuelled in the second half of last year.

More quantitatively, it is possible to assess this trend using diesel and gasoline crack spreads (Figure 5). We saw spreads spike after Russia’s invasion of Ukraine in 2022, and diesel remain elevated even after gasoline spreads declined later in the year. To us, this indicates that refineries have substantially overproduced diesel to cope with greater demand from natural-gas substitution.

We should acknowledge too that the imminent ban on imports of Russian diesel will have contributed to stockpiling efforts, and that burning diesel generates significantly more CO2 emissions than natural gas – two different ways in which the cost of diesel is likely to be high.

Figure 5. Oil Crack Spreads (Refinery Cash Product Margins)

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Source: Bloomberg and PVM Oil; as of 19 January 2023. Indices used are QSCO1 (diesel) and GEBBM1 (gasoline).

With contributions from Valerie Xiang (Man Numeric – Associate Portfolio Manager), Adrian Edwards (Man GLG – Portfolio Manager), and Jamie Lewis (Man GLG – Senior Analyst)

1. Toyota’s Slow Transition to Electric Car Shows Japan Auto Industry’s EV Doubt - Bloomberg
2. www.wsj.com/articles/u-s-ev-sales-jolted-higher-in-2022-as-newcomers-target-tesla-11672981834
3. Source: Climate Group, May 2022.