Michael Browne, Portfolio manager, European long/short at Martin Curry (a Legg Mason affiliate)
It has been an eventful year so far for European equities with some tangible signs of recovery alongside political and economic upheaval. Against a backdrop where macro factors continue to drive investor sentiment, Michael Browne shares his thoughts on what issues are likely to affect the markets for the rest of 2015 and beyond.
After what was a choppy start to the year, there are distinct reasons to be positive for the next six months and into 2016. The major factors driving European markets are by now very familiar. The debt crisis in Greece continues, as the country missed its repayment deadline on a x1.6 billion loan to the International Monetary Fund (IMF), and exiting the eurozone is a very real possibility. In addition, ongoing political tensions remain between Russia and Ukraine.
Monetary policy is still a crucial factor: the European Central Bank (ECB) introduced its quantitative easing (QE) package in March – with x60 billion (US$ 67 billion) a month being pumped into financial markets via bond buying.
The ECB has engineered a decline in the euro over the last year, which is positive for economic growth and corporates and QE will ensure interest rates stay low or even negative into 2017 and beyond. The central bank could be of importance yet again depending on what unfolds in Greece and what action the bank decides to take.
Against this backdrop, rising corporate earnings, helped by factors such as weak oil prices and low interest rates are reflecting a recovery in the overall health of the economy.
As we approach 2016 there are a number of factors which pose risks for European markets. There is the continuing possibility Greece could leave the Eurozone (although this is not the threat it once was to the single market), further conflict in Ukraine or even the slowdown in the Chinese economy.
Using our traffic lights , macro matrix and our company visits we are able to build a picture of the macro environment and to ensure the portfolio is optimally positioned. But as ever, the key factor is our focus on stock fundamentals and the individual outlooks for companies.
Europe will never be anything other than volatile but we are optimistic. However, the outlook is improving over the next 18 months. If business and consumer confidence continues to pick up, we will see earnings growth in 2016 accelerate to levels not seen since 2006.
Without a shadow of a doubt, relative to the last seven years, we are seeing a very significant recovery across Europe. This has been faster in Spain and slower in Italy, which is coming out of four years of recession.
Looking at GDP growth across the EU in aggregate, there we see a trend of clear and consistent acceleration, moving from a decline of 0.5% in 2012 to forecasts of 1.8% for 2015 and 2.0% in 2016.
In terms of earnings, the first three months of the year was the first quarter of positive earnings momentum for four years. Expectations are positive for earnings growth in 2016 and 2017, with earnings per share on the Stoxx Europe 600 index at 11.9% in 2016 and 11.0% in 2017.
This is broadly in line with our expectations. A weaker currency, fluctuating oil prices and low inflation keeping interest rates down create good conditions for economic growth.
In general, across a range of different measures, including price-to-book, price-to-earnings and dividend yield, valuations currently remain close to or a little above the average, in historical terms.
Markets in the year are up around 9% on a local currency basis – about 6% of that was due to a market rally in the early part of the year.
The rally, which began in mid-January with the announcement of QE by the ECB and continued into February, was further stoked by a temporary ‘resolution’ of the Greek debt crisis and a ceasefire agreement between Russia and Ukraine. It was mainly seen in sectors which had suffered in the previous six months – banks, miners and oil.
We did not benefit from the rally, basing our strategy on earnings momentum and growth at a reasonable price (GARP). While this may have appeared to be a missed opportunity, I believe the rally came as a surprise to many.
The last three days of April in particular were tumultuous, as the euro rallied almost 5% against the US dollar, 10-year Bund yields tripled, the price of oil rose sharply and equities declined significantly. These ructions did impact the strategy but good performance in May meant it rebounded quickly. The strategy has performed positively for the year to date, adding alpha in both longs and shorts, as well as protecting the portfolio during market drawdown periods.
We believe the key to good performance during periods with this level of volatility is patience. We have consistently said that while the first half of 2015 would be choppy, prospects would begin to improve in the remainder of the year and into 2016.
The one significant change we have made is in raising our gross exposure, aiming to ‘buy the dips’ and capitalize on market fluctuation. We believe the current situation in Greece offers an opportunity to do this.
We are focusing on sectors where the weak euro and rising demand are delivering a competitive advantage. There are three areas in particular I would highlight – industrials, consumer discretionary and financials.
Our aim is to construct a portfolio which is well-placed to benefit from the economic recovery and low interest rates, but at the same time has the potential to take advantage of any asset bubbles which might be created as a result of QE.
As ever, our focus is on stock fundamentals. We believe it is also important to understand the macro environment to ensure the portfolio is optimally positioned. While Europe remains volatile, we are optimistic.
The share rally early in the year aside, the markets have performed in line with our expectations. The first half of the year has been a curate’s egg as earnings estimates rose but GDP growth was affected by weak oil and gas prices. We are positive about the signs for the future – the indicators point to an improvement in the second half of this year and more importantly in 2016.