Outlook 2021: Europe

Europe’s economy recovered strongly over the summer after being severely affected by Covid-19 in the spring. However, a second wave followed in the autumn.  

Azad Zangana, Senior European Economist, has upgraded his 2020 GDP forecast for the eurozone to -7.1% from -7.8% for 2020. For 2021, he forecasts growth of 5.2%, which he calls “a solid recovery”.

Forthcoming stimulus should help to support eurozone economic growth through 2021 and beyond.

“Poland and Hungary are currently holding up progress on the EU recovery fund, but we expect disbursement in the second half of 2021, leading to increased investment activity in 2022,” Zangana said.

For anyone considering an investment in European equities, now could be the time to take stock of how the region has changed. Far from being dominated by financials, as was the case ten years ago, Europe now offers more balanced exposures.

Below, our investors consider the opportunities that lie ahead as we go into 2021.

Lockdowns in the spring, and again in the autumn, restricted the ability of eurozone businesses to operate as usual. However, European companies have weathered the difficult 2020 well and are generally in good shape.

Fund manager Martin Skanberg said: “Corporate earnings for the third quarter of 2020 (the latest available) were very strong. We estimate Europe had the highest proportion of earnings beats in ten years. This shows that the pent-up demand was there after the first phase of the virus.

“It also demonstrates how companies have been able to control costs, albeit partly through measures such as lack of corporate travel. This should stand them in good stead as the virus impact fades and sets up European companies for a solid earnings recovery in 2021.”

Focus on a green recovery

Recovery funds will come through in 2021, with a particular focus on the €750 billion Next Generation EU scheme. This is designed to build a greener, more digital and more resilient Europe. Loose monetary policy from central banks will also lend support.

 “There is substantial fiscal stimulus coming through in Europe and the US as the recovery from Covid-19 takes priority,” Skanberg said. “This will help support equities, as will the measures taken by the European Central Bank. The emphasis on a ‘green’ recovery is encouraging and should support stocks related to renewable energy, for example.

“Overall, as the effects of the pandemic fade and the economy recovers, I would expect economically-sensitive parts of the market to do well, such as materials. This could also include stocks that will benefit from the re-opening of those parts of the economy most affected by Covid - like engineering firms in the aviation sector, for example.”

Is it time for rotation?

After a prolonged period of outperformance for growth and quality stocks, the conditions may be in place for a change.

“There are signs that the threat of permanent deflation may be receding,” Skanberg said. “Stimulus measures are combining with economic recovery and a reconfiguration of supply chains as companies seek more local suppliers. Rising prices tend to favour more lowly-valued parts of the market, which have been left behind in recent years. We could see a rotation into these value areas and away from some quality parts of the market that have become expensive. Markets could be volatile as this plays out.  

“Other areas of the market may continue to face challenges. The energy sector has been under pressure amid subdued oil prices, lower dividends, and the increased importance of environmental factors for investors. That combination of headwinds for the sector may still prevail in 2021.”   

Sustainable investing was thrust into the limelight by the pandemic, not just due to the focus on how companies treat their stakeholders but also the performance of sustainable investments.

The MSCI Europe ESG leaders index returned -1.9% year-to-date compared to -5.6% for the MSCI Europe index (source: Morningstar, as at 30 November 2020).

Nicholette MacDonald-Brown, Head of European Blend, said: “It has been really encouraging to see the strong relative performance of sustainable investment products this year. What this demonstrates to us is that sustainable investing is no longer viewed as a luxury – something investors can only afford to think about during a bull market.”

Fund manager Scott MacLennan thinks sustainability has increased its credibility among sceptical investors. , “2020 has been a test for sustainability in judging how it adds value,” he said. “Having passed that test, sustainability is now accepted as a core part of company policy and fundamental company analysis.”

People as well as planet

The broadening out of the conversation around sustainability is something that has been evident in 2020 and should continue beyond.

“Climate or environmental factors had previously dominated the discussion around sustainability,” MacLennan said. “The pandemic brought concerns around people to the fore, with companies’ treatment of employees under greater scrutiny than ever. We would expect this balance to persist into 2021 and beyond.

“Companies have a range of different stakeholders: employees, customers, suppliers, regulators, the environment, and shareholders. The relative importance of these different stakeholders at any given time will ebb and flow depending on wider events but sustainability is certainly no longer perceived to be predominately about environmental issues.” 

Regulatory ambitions to rise

The urgency of the need to respond to the pandemic did put on hold a number of initiatives to address the climate crisis. The postponement of the COP26 climate conference in Glasgow is just one example.

“Europe has been at the forefront of sustainability from a regulatory point of view, but there was a hiatus due to Covid-19,” MacDonald-Brown said.

“As the pandemic fades, we would expect regulation to pick up and additional tools to be introduced to measure progress. We also hope 2021 will be the year that shows sustainable investing is not simply the same thing as quality growth investing. Quality growth companies tend to have consistent returns and this consistency has been prized by investors in recent years.

"As the economy strengthens in the wake of the pandemic, there is scope for cheaply-valued companies to generate better returns. These kinds of companies can also be sustainable investments particularly if we, as investors, engage with them and help to effect positive change.”

Innovation will be crucial if Europe is to transition towards a low carbon, digital economy, in line with the goals of the Next Generation EU recovery plan.

Fund manager Paul Griffin said: “I hope 2021 will be the year when outdated perceptions of investing in Europe start to change. There’s a popular narrative that Europe is simply a play on global growth and that there’s nothing particularly new or innovative happening. That isn’t the case.

“Seven of the top ten most innovative countries in the world are in Europe, according to the World Intellectual Property Organization’s 2020 Global Innovation Index. The top two are Switzerland and Sweden, while the US comes in third.

“In recent years, innovation has often been associated with some of the large US technology companies. These companies have transformed how we communicate, shop, and consume news and entertainment, and have seen enormous share price gains. People often ask where the European equivalents of those US tech companies are. But innovation can be much more than those consumer-focused technologies which keep us glued to our screens.”

Innovation to solve the world’s challenges

“There’s a growing emphasis within the investment industry and beyond on the UN’s Sustainable Development Goals (SDGs),” said fund manager Leon Howard-Spink.

“These are the big challenges facing the world today, from climate change to food security to healthcare access, and many more. There’s a huge potential opportunity to generate strong returns from companies who are targeting the issues outlined in the SDGs.

“Take medical technology, for example. The focus this year has been finding a Covid-19 vaccine and innovation has been crucial to that process. Once approved, the vaccines need to be manufactured at scale and distributed. Some of the vaccines need to be stored at ultra-low temperatures requiring highly specialised vials. Europe is home to companies who have these kinds of advanced manufacturing capabilities and specialised products.”

Griffin highlights how innovation creates products that lead to higher market share, open up new markets and help advance the UN SDGs.

“Electric vehicles (EVs), for example, are an important part of the move to a more sustainable transport infrastructure,” Griffin said. “EVs rely on specialised semiconductors that only a handful of companies can produce. Several of these are based in Europe.

“We also see investment opportunities in areas such as materials, data and processing, healthcare, and engineering. European companies operating in these areas may not be well-known names but there are many who are leaders in their fields. Europe is already ahead of the game on sustainable issues at both government and business level; the investment proposed in Next Generation EU offers a further tailwind.”

European companies should be well-placed to benefit from an economic recovery, as long as Covid-19 headwinds fade, according to smaller companies fund manager Luke Biermann.

“2018 and 2019 were tough years for the European manufacturing sector. Italy was in recession and Germany avoided recession by a whisker,” Biermann said.

“What this means is that manufacturing businesses had already adapted to reduced demand. They didn’t go into the Covid-19 crisis with a huge cost base or excess inventory. That leaves them well-positioned for the coming recovery, assuming the pandemic effects start to fade.

“Loose monetary policy and government support measures also help create the potential for a recovery in manufacturing. Other economies – such as China – have already recovered from the crisis and demand is growing. This could help lift exports which are particularly important for Europe. Even when you exclude trade within the eurozone, exports are 28% of the eurozone economy, compared to 12% for the US, 19% for Japan, and 20% for China”.

Digital shift here to stay

The shift towards a digital economy has been a feature of the pandemic but will continue beyond it. Microsoft’s CEO Satya Nardella, for ecample, said that two years of digital transformation has occurred in just two months.

Luke concurs that the switch to digital at the start of the pandemic was hugely disruptive.

“Businesses – both industrial and consumer focused - who didn’t have a digital strategy to reach clients suffered immediately as the pandemic took hold,” Biermann said.

“There’s been a need for domain experts, consultancy firms and specialist digital marketing companies to help those businesses come up with strategies quickly. That’s going to keep evolving as businesses have a more urgent need to improve in this regard if they’re going to remain relevant. As an investor in smaller European companies, those kinds of specialist firms offer exposure that can be more difficult to access through larger companies.”

Gaming - not just for lockdown

There are specific industries where smaller companies can offer exposure to trends that are more difficult to access through larger companies. Biermann highlights the video gaming industry as one such example.

“Video gaming continues to evolve very rapidly. The pace of change over the last 40 years has been incredible and innovation continues to come through. Video gaming is associated with lockdown in some investors’ minds, but that ignores the enormous potential for structural growth in the sector.

“We’ve seen huge numbers of people take up video gaming. We’ve also seen games evolve so that they’re as much about socialising as the game itself. Then there’s the ongoing innovations in e-sports and virtual reality. From an investment standpoint, the potential for monetising these developments is very exciting. Pricing has largely stood still, but that’s starting to change.”

Fellow European smaller companies fund manager Hannah Piper agrees that gaming is an industry that can continue to do well into 2021 and beyond. “Covid winners are not necessarily vaccine losers” Piper said. “Many of the habits formed during lockdown are likely to endure. Video gaming as a form of entertainment and socialising looks set to be one of them.

“Another lockdown hit has been meal kit deliveries. Again, I think this is a trend that will last beyond the pandemic. Lockdown and working from home means people have been preparing more of their own food than ever and many are becoming bored of their own cooking. Even once restaurants re-open, meal kits provide variety and are a more affordable treat than going out.”

‘Winner takes all’ in the travel and leisure sector

By contrast, other industries have been severely disrupted by the virus. Travel is one of the most obvious, with restrictions on national as well as international travel, quarantine rules, and vastly reduced business travel. However, demand could return extremely quickly once vaccines restore confidence that travel is safe. Piper notes that there will be “big winners and big losers” from the crisis and that the companies who were strongest beforehand may be best placed to thrive once it is over.

Piper said: “The hotel industry is one where the best-in-class operators, with a solid financial position, are likely to emerge from the crisis even stronger. Supply will fall as weaker hotel operators go bust or sell assets. The stronger operators will be able to cherry-pick the best assets from these weaker businesses. As demand picks up, they will be in a good position to raise prices.”

“It’s the same story for airlines and tour operators. Even before the pandemic there was capacity leaving the market, with Thomas Cook going bankrupt last year for example. Capacity has been cut drastically during the crisis. There was a brief window during the summer when people in Europe were able to travel, and there was a race to make flights and holidays available.

“After a winter of restrictions, the pent-up demand for travel once vaccines are available will be enormous. Companies with strong balance sheets that have been able to weather the crisis will be the winners.”    

Turning to private equity, demand for European investments looks set to remain strong. Alternatives Director Emily Pollock says deals in the European private equity space have picked up in the latter part of 2020.

“The technology and healthcare sectors have been particularly active,” Pollock said. “We’re now starting to see activity in other sectors pick up, including education and consumer staples.”

There are some long-term trends in private equity that Emily expects to remain in force in 2021 and beyond. “Something we’ve continued to see this year is that companies are tending to wait longer before listing on public markets. This means companies will often wait until they are larger before pursuing a listing on public markets and there are a greater number of acquisition targets for private equity buyers.”

Emily says interest from overseas investors in European private equity remains high. “There’s a number of reasons for this. Firstly there’s a plenty of scope for consolidation in Europe. Many industries are very fragmented with a large number of small, local firms. That means opportunities for private equity buyers to invest in a business, then acquire competitors, and/or help the business to expand beyond its local market.

“Secondly, Europe has a high proportion of founder- and family-owned firms. Given the ageing population, many founders are looking to transfer their businesses to the next generation. However, family members may not have the right skills, or the desire, to take it over. That’s where private equity can step in, perhaps via a management buyout where private equity finance can help existing staff buy the business.

“Thirdly, there are a number of high quality acquisition targets in Europe. Goods made in Europe are perceived to be high quality and so exporters can take advantage of growth in overseas markets.”  

From a client perspective, Emily adds that new products are being developed that can help bring private equity investing beyond its traditional sphere.

“We are seeing greater democratisation of private equity so that this asset class can be made available to a wider range of investors. Funds that include a mix of both public and private companies are helping to make private equity investing an option for more people.”

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