Fund Research Analyst
2019 represents an important year for Europe. The continent’s external environment deteriorated sharply in 2018, with growth in China slowing and trade tensions ratcheting up across the globe. But Europe was also hurt by domestic issues, most notably political disruption in Italy and France, but also problems in Germany’s auto sector amidst the fallout of the diesel scandal.
Is Europe facing another year of bleak prospects, or is the region being written off too soon? To help answer these questions, we invited twenty European fund managers, investing across different market-cap and investment styles, to give us their thoughts on their 2019 outlook, positioning, and expectations. What follows are the key conclusions, with our managers arguably reflecting a more positive outlook for their portfolios than for Europe itself.
Clear divide between those feeling more positive than twelve months ago
There is a clear divide between European fund managers who are feeling more bullish compared with 12 months ago, although even the optimistic are only cautiously so. Given how elated markets were during 2017 and into early 2018, this is not a big surprise; bloated valuations and the prolonged upwards trend made some investors uneasy and many managers previously told us that they were struggling to find new ideas.
Perhaps some were expecting a poorer year for Europe in 2018 and are relieved that we have now seen a reversion to the mean in valuations (debatable). However, the general consensus amongst fund managers is that volatility has driven valuations down to attractive levels, presenting good entry points and aiding idea generation for stockpickers.
Portfolio positivity at odds with broader views
Despite mixed levels of bullishness, all of our surveyed fund managers are pitching the probability of a 2019 recession in Europe at below 60%; what we referred to as possible but unlikely. Around a fifth of our managers thought that a recession was outright unlikely. Slightly more than a quarter thought that a recession was unlikely on balance, and, perhaps worryingly, a third thought a recession was possible and depended on how conditions evolved.
Market shocks and volatility are broadly expected to continue this year due to various political uncertainties including Brexit, Italy, unrest in France, European parliamentary elections and the potential for leadership changes in some of Europe’s biggest economies. Overall though, European managers don’t think we’re in dire straits. As one manager commented, ‘companies across Europe are conditioned to uncertainty’ and ‘the tone of our conversations with management teams has been reasonable.’
Interestingly, one fund manager placed the importance of US-China trade tensions ahead of the UK’s departure from the European Union. Concerns around whether the US might shift their focus towards Europe and how this will affect autos exports was another standout.
Central bank policy
There continues to be a lively debate within the financial press about the impact of tightening monetary policy, but this does not seem to be reflected by our group of European managers to the same degree. This is partly due to investment styles – some invest in family-owned business less reliant on bank lending – but some question whether the central bank is even able to pursue quantitative tightening over the next year, further supported by the lack of inflation.
Few managers chose to expand on their opinion that quantitative tightening would be a (not overwhelming) headwind and that highly leveraged companies should be avoided. Some believe that any impact on their portfolios will be short-term but this could also present opportunities as long as they stay focused on company fundamentals. A beneficiary that some highlighted was the financial sector, should we see a rise in interest rates.
Perhaps active managers feel that they can mitigate any adverse impact relatively easily with Bank of America suggesting that the combined balance sheets of the Federal Reserve, ECB, Bank of Japan and Bank of England will only be 4% smaller in 2020.
Earnings growth seen as a beacon of optimism
Stepping away from the doom and gloom, a couple of managers highlighted that earnings growth should remain above trend in 2019, with history showing that European companies are adaptable when facing periods of political trauma. Another focus was on the durability of the effects of political situations on markets, with the expectation that a lot of these factors are short-term and will in fact have minimal impact on portfolios over a long-term period. And finally, the ever hopeful pointed out that despite all of this noise, if we do start to see positive news flow, resolutions to issues such as Italy’s fiscal situation, and the subsidence of these political noises then this should in fact be a tailwind for European markets. Some argued that we’re starting to see this already.
We can see some correlation between managers’ expectations regarding inflation and the direction of euro strength; generally those that expect an upside surprise also anticipate appreciation of the euro. Similarly, those that expect inflation to be in-line with consensus think that the euro is likely to trade sideways. The responses were broadly mixed so it is difficult to draw an overall conclusion from these responses but, at the margin, it looks like fund managers are more positive than negative regarding European market outlook – as demonstrated by how few managers are expecting a European recession.
Focusing on the European equities asset class, two arguably optimistic managers expect 11%+ returns in 2019. Interestingly, the responses came from one manager with a large-cap, value-biased portfolio and another with a small/mid-cap, quality focused portfolio; two strategies arguably on different sides of the fence in terms of what market conditions would favour each.
Most of our respondents expect absolute performance to range between -5% to +10% during 2019, and not one of the twenty expect performance to be lower than -5%. Behind this thinking is the belief that much of the negative news from political noise is already priced in, but also an acute awareness of how important it is to select the winners and not get caught holding the losers.
So where are managers seeing opportunities?
Opinions on which specific sectors constitute the winners and losers differ widely amongst our fund managers. However, an identifiable theme is the call for some level of defensive and quality exposure, or at least a consideration for the balance between defensive and cyclical exposures given the anticipated continuation of market volatility. In line with this, some are finding opportunities within the healthcare (particularly medical technology companies), staples and utilities sectors. Many are avoiding purely cyclical sectors; autos and luxury goods, with these areas vulnerable to the knock-on effect from a US-China trade war and the risk that Trump may turn his attentions to Europe’s trade surpluses.
Various managers are avoiding European banks because of structural and strategic challenges, including disruption from online competitors and a lack of pricing power. Conversely, a manager with a value-focused philosophy believes that there is too much pessimism around the European banking sector, a theme we see reflected more widely across value managers. They point out that earnings would need to fall by c. 30% for valuations to fall to their historical averages, and that bank share prices are therefore currently priced for a recession.
The sectors sitting in more of a grey area are energy and industrials. The latter sector is unsurprising given the myriad of companies that fall under the industrials umbrella – some managers are attracted towards the quality market leaders but a couple think the sector is still overvalued.
Fund managers with a philosophy that favours companies exhibiting pricing power tend to be
avoiding energy exposure due to volatile commodity price movements. On the opposing side of this, fund managers that are overweight the sector believe that valuations are attractive and fundamentals remain strong for some of these companies.
No, we didn’t forget about Brexit
While this was a European survey, we did ask fund managers whether they thought the UK leaving the EU would lead to investors considering UK and European equities as separate asset classes. Several managers reported seeing higher demand for separate UK and European products, with some arguing that this distinction was already clear. Whether it makes sense over the longer term is an open question however; UK and European companies are often highly exposed internationally, and have the potential to be domiciled, incorporated, and listed in three separate places.
Setting up for a reasonable year?
In conclusion, it appears that optimism has fallen from the highs of 2017 but to more realistic levels. Our fund managers still see value and opportunity within Europe. While recent market volatility has been painful in the short term, this has aided idea generation as valuations have fallen. All are aware of the abundance of political situations, both within Europe and globally, and the impact that the various outcomes could have on their portfolios. It will be a rollercoaster of a year from many perspectives, so we will watch the European equity space with interest over 2019.