Europe: Desperately Seeking Growth
In recent years Europe has struggled with financial crisis, recession and poor political stewardship. Now we are seeing governments and
monetary authorities make progress towards better economic and financial stability. We believe equities could provide the most
compelling opportunities, as there is little juice left in fixed income. In any event, the watchwords will be selection and quality.
The rapid ascension of the 39-year-old Matteo Renzi to Prime Minister of Italy in February 2014 was met with great anticipation. His agenda was to kick-start structural reforms that Italy (among other European countries) needed.
The focus on reforms is apparent across Europe, where many countries are now dealing with high unemployment, high debt, deflationary forces and low or no growth. The Troika – the European Union, the European Central Bank and IMF – pushed a great deal of fiscal austerity early on in the crisis, which has made the Union fragile. Conditions are tougher than we hoped with regard to GDP growth. Despite retaining an above consensus forecast on growth, we have cut our estimates to 1.6% in 2015 and 2% in 2016, with downside risks.
A Complicated Picture for the Eurozone
Nevertheless, even with low growth through 2015, some things seem to be improving. We observe that, after a blow to confidence in the first months of 2014, the macro framework is stabilising. Moreover, two other factors could contribute positively to the Eurozone outlook: a more decisive role of the ECB and the fall of oil prices. In January, the ECB finally embraced Quantitative Easing on sovereign bonds and President Draghi confirmed that the ECB will do whatever is necessary to avoid a deflation trap in the Eurozone.
The Central Bank continues to engage in credit easing measures, such as the Targeted Longer-Term Refinancing Operations, that are bringing down borrowing costs and stabilising banks. Meanwhile, the Single Resolution Mechanism – a new European authority with the power to wind up and restructure failing banks – reduces the risk of further taxpayer-funded bailouts. Moreover, a clear indication from the ECB that the euro will continue to depreciate (our forecast are for a EURUSD exchange rate close to parity in the next twelve months) could help in regaining competitiveness and supporting Europe’s exporters. Another important factor is the fall of oil prices, that free-up income for households and reduce the costs for most of the corporate sector.
However, the skies are still not clear. We doubt that the ECB alone will be effective in pulling Europe out of the quicksand without a change in fiscal policy. On this, we believe that the success of anti-austerity forces in Greece in the recent elections could provide a wake-up call for the more intransigent part of the union to embark a more accommodative stance in fiscal policy, without compromising the structural reforms process.
The issue of rekindling growth in a way that goes beyond the mini-cycles Europe has experienced over the last decade - cycles that expose the economy to myriad external risks- remains a concern. Nominal growth is an essential condition in reducing a huge debt burden, cutting down unacceptably high unemployment levels and avoiding a dangerous deflationary spiral.
The awareness of the need for policy action is growing at all levels (both at the centralised and country level), but divisions between countries remain and seem to be paralysing decisive action. We therefore believe that 2015 will be another transitional year for Europe, with a balance of potential positives (a stronger US economy, weaker euro, a more active ECB) and downside risks (mainly driven by potential policy mistakes or worsening geopolitical conditions).
Fixed Income: Extended Valuations Across the Board
In the last few years, due to Central Bank intervention in the aftermath of the financial crisis, fixed income has been an area of the market subject to manipulation by monetary authorities. What the ECB has achieved is to compress risk premiums across the fixed income spectrum. We believe that this market manipulation is, and will continue to be, a major factor in 2015. However, this strategy is becoming more and more risky and it diminishes opportunities for capital appreciation looking ahead. As a consequence of yield compression in core government bonds, the cushion provided by rates is low: in a scenario of rate normalisation – driven by the Federal Reserve – it will become even more difficult to find positive returns, in our opinion. Thus, in its global context, European fixed income is no sure thing in the event of a change in sentiment on rates. Focusing on the domestic market in isolation, a weak European economy could support a low-yield environment. However, with this low yield it is probable that a rise in US interest rates would have consequences on the European yield curve. As value investors we are not comfortable with these levels. While we don’t expect a strong rise, our outlook for rates in 2015 is more bearish than it was in 2014.
We believe that monetary market manipulation is, and will continue to be, a major factor in 2015.
We also believe that peripheral bonds are less attractive at current levels. Spreads and yields have fallen on the expectation of more aggressive Central Bank policy and on pending potential quantitative easing, but the periphery is also exposed to disappointment as economic fundamentals fail to bridge the gap with the core. A deep deflationary scenario (not our central case) combined with low or no growth could place further pressure on debt sustainability.
While the picture suggests that there is not much value left in fixed income, it's worth observing that supply and demand dynamics could help to maintain some momentum in the market. The supply of bonds is steady but decreasing, while demand remains firm. Central Banks are still very active players, and the de-risking process driven by regulators might continue to support global demand for fixed income. A similar trend is apparent to us in the credit market: there has been consistent demand for investment-grade credit and we’ve seen inflows into the asset class almost every week this year. In a fragile economic environment, we also see companies being fairly conservative and not re-leveraging. That should keep issuance of corporate bonds contained. However, as per the government bond market, there is not much value left in credit
We therefore believe that expected returns from European fixed income in 2015 will be lower than in recent years. In this environment, security selection will be even more important in delivering alpha1, as will a flexible approach on duration to capture sudden changes in market sentiment.
Equities – Focus on Sustainable Growth and Income
In 2015, we still see opportunities in the European equity space, driven by active management and stock picking. Corporate earnings exhibit decent growth. In the last four quarters2, average earnings reported by European companies have grown at a rate of 10% to 11% and we expect the trend to continue in 2015 and 2016. In our opinion, these numbers are consistent with a GDP growth of about 1% and are consistent with what we have seen in the past with these levels of growth. However, it is not just earnings growth, but also earnings quality and growth sustainability, that will be among the most relevant themes for European equities in 2015. So our focus will be on the quality of growth: combining earnings growth with the return on capital deployed.
In our view, in 2015 there will be a more rational search for income.
We believe there are opportunities both in defensive and cyclical sectors, although we are favouring cyclical sectors, and companies exposed to North America and in some cases to emerging markets. As the euro continues to depreciate against major currencies, these companies should continue to outperform those more exposed to European domestic demand, which remains weak. Also the fall of oil prices could be a positive factor for earnings growth in the Eurozone (as it reduces costs) and could help to close the earning gaps with US companies. Another important theme for stock picking in 2015 is what we call “sustainable income”. We aim at selecting companies with dividend yields that are both sustainable and growing. With interest rates at zerobound, there has been a greater emphasis on finding dividend-paying stocks over the last few years. We have seen that reflected in the performance of utilities, telecoms and other securities tilted towards yield. Some analysts are already describing this dynamic as a bubble in yield.
We therefore believe that in 2015 there will be a more rational search for income. Combining quality and sustainability of income with equity valuations in the chart above, we see the most appealing opportunities in the upper right quadrant – in cyclical sectors. Banks are of particular note: considering their position in the chart, they could seem the most compelling investment case. The caveat is that most of this is a consequence of a base effect. This sector went through a deep restructuring after the crisis and is still searching for a new “normal”. Valuations are quite low and any improvement in earnings growth could benefit the sector.
The sector cannot therefore be disregarded, especially in the search for yield, but particular attention must be paid to each individual investment case. In conclusion, the most important consideration for our European equity team for 2015 will be identifying companies that are able to grow dividends, sustain that growth and that carry fair valuations. We are focused on selecting companies that have a well-balanced capital allocation and a growing dividend, not simply an attractive yield at the detriment of other capital needs such as plant equipment, additions to working capital, and strategic acquisitions.
This does not diminish the importance of managing volatility. In the last five years we have seen sudden changes of direction in the market, so it's important for active managers to stay vigilant in realising profits and reinvesting at the nadir of the cycle.
At present, we believe there is too much gloom around Europe and there could be a positive surprise to the upside as equities offer good value. In 2015 the strategy to deliver alpha will be a case of selection and opportunistic active management.
We believe there is too much gloom around Europe and there could be a surprise to the upside as equities offer good value.
1 Alpha — Measures risk-adjusted performance, representing excess return relative to the return of the benchmark
2 Source: MSCI, Pioneer Investments, Q4 2013-Q32014.