Investing in Europe has become a daunting endeavour in a challenging economic environment and macro headlines aren’t likely to improve – at least before the second half of 2023 according to one European fund manager.
But this is not a solo opinion. François Cabau, senior Eurozone economist at Axa Investment Manager, sees a “grim outlook” for the Eurozone, despite it having shown some resilience due to positive impetus from the Covid reopenings, a swift convergence to more normal savings behaviour and strength of gross disposable income, underpinned by a strong labour market.
“Constrained energy supply and faltering demand are likely to push the Eurozone into a marked recession this winter, while a changing economic structure and tight monetary policy will lead to a sub-par recovery,” he said.
“Monetary policy dominance will generate increasing worries about public debt sustainability, while the future of European Union fiscal rules and the Next Generation EU package are likely to bring additional political and policy challenges.”
A recovery will come, Cabau said, but even in his optimism, he remained gloomy, adding that it will be a weak one.
“Mending the supply side of the economy – changing the energy mix (especially for Germany) and securing supply chains – is a process that will likely take years. While uncertainty runs high, the quantum and/or price adjustment will result in a permanent supply shock,” he said.
“Reflecting the persistent constraints the economy will face, we have pencilled in 0.22% quarter-on-quarter real potential growth on a sequential basis through 2024. We do not expect the GDP level of the third quarter of 2022 to be recouped until the second of 2024.”
Luckily, however, investing in European equities is not the same as investing in Europe, as Mark Nichols, manager, among others, of the £3.2bn Jupiter European fund, noted.
Performance of fund year-to-date against sector and index
Source: FE Analytics
“The consensus view is bleak for the European economy, yet the corporate outlook has some reasons for optimism. After all, it is always darkest before dawn, isn’t it…?,” he said.
“If the market shifts its view from macroeconomic doom and gloom to focusing on how individual companies are doing – we think that quality companies with exposure to long-term growth trends should outperform.”
According to the manager, secular trends might provide momentum to some industries, notably in energy and healthcare.
He said: “Companies that can create products and services to help improve the efficiency of buildings should be well placed to benefit, and there is a clear need too for companies that can help to counteract the increase in diabetes and overweight problems around the world.
“Additionally, fewer and less constraining Covid restrictions, as well as easing supply chain bottlenecks, pair with the fact European stocks are 50% cheaper compared to the US: the widest discount in more than five years.”
Martin Skanberg, manager of the €1.9bn Schroder ISF Euro Equity fund, fears that the stock market momentum generated by expectations that inflation may have already peaked, at least in the US, may continue into the first part of 2023, but could fade later in the year.
Performance of fund year-to-date against sector and index
Source: FE Analytics
“Just as the expected recession has not arrived yet, neither has the anticipated sharp downgrade to corporate earnings. Both factors could help profits to remain resilient, even as additional cost pressures come from higher wage demands,” he said.
“But at the same time, we also have to consider that higher interest rates mean higher financing costs for governments, corporates and individuals, with consumption and investment likely to be hit. As quantitative tightening takes place, and debts start needing to be refinanced, we may see any early positive momentum for the stock market fizzle out.”
Against this backdrop, energy, which was the top positive performer in the MSCI Europe ex-UK index in 2022 with a 27.9% gain (year-to-date as of 31 October 2022), is “unlikely to outperform the index to such an extent in 2023”, according to the manager, who took a shorter-term view on the sector than Nichols.
On the other hand, banks are a sector that could do well.
“Many Eurozone banks are still looking attractively valued and higher interest rates are positive for the repricing of loans. Clearly, a recession would cause a rise in bad debts, but if that recession is short or shallow, then the negative impact would be more limited than some might fear.”
Another area that has particularly suffered in 2022 which is “likely to reverse” is small and mid-sized companies, said Skanberg.
“Even a moderately better year for Europe could catch out many in the market. The positioning has been very negative with investors deserting higher-risk areas, including small- and mid-sized companies. Any better performance could mean this changes swiftly,” he said.
“In general, more favourable sentiment towards shares tends to result in outperformance for small-cap stocks compared to large-caps, when risk appetite returns.”
Encouraged by ebbing inflation figures, Sharon Bentley-Hamlyn, manager of the Aubrey European Conviction fund, hopes to see central banks hiking interest rates by 25 basis points in the spring, instead of the current 50.
“Reducing interest rate hikes are already dampening upwards pressure on the US dollar, which is helpful in relation to European currencies and the Yen. This is positive for non-US equities and may encourage dollar flows into other markets, notably Europe, Japan and emerging markets,” she said.
“It is by no means too late to be investing ahead of this next cycle. If the returns over the next decade reach even half the return our clients have had from the bottom of the global financial crisis to the end of 2021, (almost 700%), investors will do very well indeed.”