Look beyond Europe for better value, but stay put for high yields

Politicians may be debating future relations with Europe, but it seems that investors have already made up their minds. In the second half of 2018, net retail outflows from European equity funds available to UK investors hit £1.4bn, as MSCI Europe ex UK index fell 10 per cent and Europe became the worst performing major market of 2018. This was in stark contrast to positivity at the start of last year when European equities were tipped to deliver stellar returns, and the first six months of 2018 when European equity funds available to UK investors made net retail sales of £308m.

The high outflows from Europe funds in the second half of 2018 were in part due to general bearishness on all equities, but negative feelings on Europe were particularly strong, with £400m withdrawn from European equity funds in December alone, as chart 1 shows.

Looking at markets, it’s easy to see why – Europe generally hasn’t offered much growth or stability for a decade. Europe was not the best performing region in any calendar year between 2009 and 2018 when compared with Asia, Japan or the US, each of which claimed the top spot in at least three of the past 10 years (see table 1).

And although Europe was never the worst performing region, Sterling/euro exchange rate volatility meant that, in effect, for UK investors it was in three out of the past 10 years (see table 2).

Long-term investors have been patient with the region even though it is generally affected by political problems and macroeconomic concerns. Europe did well in the earlier part of this decade, in particular European smaller companies with MSCI Europe ex UK Small Cap index increasing nearly 80 per cent between June 2012 and June 2014, but this has not lasted. 

Now the outlook does not look great, with soft economic data warning of difficult times ahead. Factory orders in Germany declined by 1.6 per cent in December, in contrast to the 0.3 per cent increase expected by analysts. And German factory orders have declined by 7 per cent since December 2017 mostly due to overseas orders falling away.

This highlights the main issue with European equities, in particular the region’s exporters. Europe is closely aligned to global growth because it has huge exposure to China, other parts of Asia and the US, in particular from consumer goods and manufacturing exports. Last year’s slowdown in global growth, concerns over Chinese economic growth, and the trade war between the US and China, had a significant effect on European companies’ earnings outlook, and investors sought protection from this by reducing exposure to European equities.

Rory McPherson, head of strategy at Psigma Investment Management, says the European business cycle looks fragile and is not likely to support higher equity prices soon.

“Growth is deteriorating,” he says. “Purchasing manager indices (PMIs) continue to trend down and underwhelm, and credit growth has rapidly tailed off. Earnings are stuttering with around 30 per cent of the market having reported results. And fourth-quarter (Q4) European earnings per share (EPS) growth stands at 1 per cent year on year, down from 8 per cent in the third quarter. Earnings surprises are weak, with positive surprises at 47 per cent – the lowest since Q4 2014 and well below the long-run average of 54 per cent. The worst earnings growth has been in Germany and Spain.”

Kasim Zafar, a portfolio manager at wealth firm EQ Investors, reduced European equity allocations in the firm’s balanced (medium risk) portfolios in 2018 from 20 per cent to 12 per cent.

“Equity markets in all regions lost their momentum after the market tumbled in the first quarter of 2018,” explains Mr Zafar. “In Europe that momentum never really recovered, but market valuations didn’t go down significantly enough to become a positive factor. The forecasts for 2018 collectively envisaged a globally synchronised economic expansion, but almost every investment strategist and economist was wrong-footed by the credit contraction in China that put the brakes on growth. Europe has a very open economy and relies heavily on trade. As China slowed down and global trade volumes decreased, it had a consequent slowing impact on European businesses.”

There are also more localised issues such as weakness in Germany’s car manufacturing industry after it was discovered in 2015 that Volkswagen (VOW3:GER) cars were fitted with devices to circumvent emissions tests, and due to structural changes such as a move to electric cars and shift away from diesel. There are also concerns over Italian and French politics.

And investors remain nervous about the European Central Bank’s (ECB) actions. Like the UK and US central banks, the ECB engaged in quantitative easing following the financial crisis and has now started to take away this support. Interest rates remain at historically low levels, which can be good for markets as credit conditions remain favourable for companies. But in Europe there is not currently enough economic growth or inflation for the ECB to move fully towards normalisation like the US Federal Reserve.

Better value elsewhere

Although these factors have created negative sentiment towards European equities, their valuations are still relatively expensive. “European equities are less expensive than US equities, but Asian, Japanese and UK equities are more attractive,” says Mr Zafar.

Mr McPherson adds: “Europe looks cheap at 12 times forward earnings. However, there are cheaper markets such as the UK and Japan on 11.5 times forward earnings. And, when you adjust for sector composition, Europe has next to no technology, so it is not cheap enough.” Technology companies account for less than 5 per cent of MSCI Europe ex UK index.

Mr Zafar has reinvested the funds he took out of European equities in US and UK equities. He accepts the former may seem like a strange choice given high US equity valuations, but he thinks tax cuts and low unemployment are providing strong momentum.

He increased the allocation of EQ Investors’ balanced portfolios to the UK market because it is significantly cheaper due to uncertainty over the UK’s departure from the European Union (EU). He adds that the UK market also has “growing earnings expectations and commodity sector exposure that would benefit if the economic slowdown turns out to be temporary, or there are stimulative policies from major governments and central banks”. 

Mr McPherson has also allocated to the UK because of valuation reasons, as well as adding to Japan.

“Europe looks interesting, but we see better opportunities,” he says. “It is no more interesting than places such as Japan and the UK which have undershot, and are more widely hated and under-owned, according to the flow and survey data we look at.”

Table 3: Valuations of global equity markets

Source: MSCI, as at 31/01/2019

But Mr McPherson thinks the European bond market does offer value, and weaker sterling and currency hedging in the bond markets has added to returns. “We prefer to get exposure to Europe through the debt markets,” he says. “As UK investors, we are ‘paid’ to hedge the debt back to sterling, which adds a further 1 per cent to our returns.”

Europe bulls

Some investors are bullish on the outlook for European equities for reasons including low valuations versus the US, meaning they offer exposure to the global economy for a cheaper price. And MSCI Europe ex UK index on average yields 3.5 per cent versus MSCI All Country World’s 2.6 per cent average yield. Beaten-up sectors such as European banks, meanwhile, offer average yields as high as 5.5 per cent.

James Calder, research director at City Asset Management, says his firm’s allocations to Europe have been steady over the past 18 months. “Europe is still cheap and is a collection of developed markets so there should be a degree of comfort,” he explains. “There are issues, and last year there was contagion from the US and China, but no asset class covered itself in glory in 2018. We were disappointed with what happened last year, but are happy with what’s happened in the year to date. European equities are an asset class that should be simple but never are. European stocks are trapped between the US and Asia, and trade at a discount to US stocks because they’re not as well run and efficient. We could see mergers and acquisitions pick up as a way for European companies to survive. And a skilled fund manager should be able to outperform the index.”

Haig Bathgate, head of portfolio management at wealth firm Seven Investment Management, says the market’s recent misgivings have created opportunities rather than reasons for pessimism.

“The issue with Europe is that catalysts for the market’s rerating are never clear,” he explains. “But you can get a good yield in the meantime. The banking sector offers over 5 per cent, so you’re being paid more to wait for the rerating than before. We may be in too early or wrong, but every time European equities sell off we add to them.”

Mr Bathgate adds that the European growth story that was touted so much during the earlier years of this decade has not gone away. He also says: “I would agree that the UK looks cheap, but the problem is that they could get a lot cheaper. We don’t buy Europe at the expense of everything else, but its risks are not as high as those of the UK, and you’re getting different exposure at quite a good discount. Macroeconomic fundamentals are an area of concern and a lot is dependent on what happens in China. But the picture is not clear, and [European] interest rates are very supportive and lower than those in the US. The European Central Bank is supporting the economy and borrowing costs are very low. So we’re not unduly concerned about the situation.”

Mr Zafar might increase his portfolios’ exposure to European equities if some things change.

“We see strength in European consumers due to continued falls in unemployment,” he explains. “So if we see some recovery in industrial activity in Europe, perhaps supported by stabilisation of growth in China or a Brexit resolution, we would probably dial up our exposure to the continent.”

Best UK, Japan and Europe value

If you plan to increase your allocation to the UK to tap into what seem like low valuations, Mr McPherson recommends getting broad exposure to large-caps. As this tactical play is based on a macro valuation rather than stock or sector fundamentals, active management isn’t necessary. And the FTSE 100 should provide a slight hedge if Brexit goes from bad to worse because UK large-caps earn about two-thirds of their revenue in foreign currencies and will benefit if sterling falls further, as is likely if the UK leaves the EU without a deal.

To get passive exposure to the FTSE 100 index, investors can use iShares Core FTSE 100 UCITS ETF (ISF), which is the largest and most liquid exchange-traded fund (ETF) tracking this index. It has an ongoing charge of 0.07 per cent and physically replicates the index by investing in FTSE 100 shares, rather than using credit derivatives like some ETFs. iShares Core FTSE 100 UCITS ETF has a good record of closely tracking the FTSE 100’s performance.

If you prefer unlisted funds, L&G UK 100 Index Trust (GB00BG0QPG09) is large and reliable, and even cheaper with a 0.06 per cent ongoing charge.

When allocating to Japan, Mr McPherson suggests getting exposure to the main market. But he also believes there are opportunities among medium and small cash-generative growth stocks, which are becoming more shareholder friendly as a result of Prime Minister Shinzo Abe’s corporate reform programme. So AXA Framlington Japan Fund (GB00B7FSWP64), which invests in a mixture of large, medium and small-cap growth stocks, alongside some value opportunities, could be a good option. The fund’s holdings have an average forward price/earnings ratio (PE) of 12.7, which is relatively cheap and suggests they have the potential to re-rate. The fund’s manager, Chisako Hardie, favours stocks in healthcare and technology. She also has a high weighting to industrial stocks, although less than the average level for funds in the Investment Association (IA) Japan sector. AXA Framlington Japan’s performance over one year is not great, but this means now could be a good entry point into this value play. Over longer periods, the fund has beaten both the Topix index and the IA Japan sector average. AXA Framlington Japan has an ongoing charge of 0.84 per cent. 

JPMorgan Japanese Investment Trust (JFJ) primarily focuses on large-cap growth stocks engaging in corporate reform. Its manager, Nicholas Weindling, currently favours industrial stocks, and technology and consumer companies taking advantage of changing trends such as an increase in tourism in Japan and exports to China. The trust is trading on a 9.8 per cent discount to net asset value (NAV), below its sector and its own three-year average.

If you want to take advantage of the yields on offer in Europe via a more defensive fund Standard Life European Equity Income (GB00B71L0M27) is a good option. This fund, which is run by Will James, is heavily tilted to financials – the European sector that on average pays the highest dividends. The fund’s performance relative to MSCI Europe ex UK index is not good. However, if European consumer or bank shares re-rate, this fund should outperform and in the meantime offers a yield of 3.8 per cent.

Table 4: Fund performance

Source: FE Analytics, as at 08/02/2019. *Winterflood at as 11/02/2019.