European long/short : scenarios for 2017

Michael Browne & Steve Frost, Portfolio Managers, European Long/Short, at Martin Currie (a Legg Mason affiliate)

Michael Browne

Political shocks and economic uncertainty were the norm across global markets in 2016 and Europe was frequently centre stage. For investors it was often a challenging period as they attempted to navigate the murky waters. However, despite the volatile backdrop, we see reasons for optimism in the year ahead

Will Europe lift itself from deflationary gloom any time soon? The simple message from us is, yes. We are more optimistic that deflation will become less of an issue in 2017. However, it will be important to monitor if this effect is only a short-term response to the recovery in the oil price to over US$50 per barrel. Perhaps the most interesting thing is positioning data, which suggests investors are still, on the whole, very sceptical and therefore remain very underweight. In short, opportunity beckons.

2016 was a long, hard, deflationary, Brexit year. While real growth rates were unchanged, nominal GDP fell, as inflation hovered around zero. At the start of the year, investors quickly understood that analysts’ expectations were well wide of reality and tumbling earnings estimates were matched by falling markets. But since the second quarter, the newsflow has been improving and although the political uncertainty (created by the British and Italian referendums) sapped investor interest, the reality is that we have seen improvements. Business and consumer confidence has been steadily improving and is now distinctly higher than where it was this time last year.

With the end of deflation and the prospect of modest inflation of around 1%, nominal GDP should be 3% plus. Why does that matter? Nominal GDP is effectively the same as sales. And sales growing at 3%, rather than 1%, will have a strong impact on the earnings, margins and cash flow in Europe.

Bull market : 50% likelihood

Steve Frost

Last year we asked how markets would respond to a US rate rise. This year the question is the same, but the backdrop is very different. As ever, while the first rate hike is greeted by dismay, the second, third and fourth are typically taken as a sign of improving growth. We are now expecting two, maybe three, more rate rises in 2017, while in Europe none. The implications for the US dollar are that it may strengthen, thus keeping commodities in check.

Oil and gas capex, a key driver of the recent industrial recession, should at least bottom out and there is a strong likelihood of a general pick up in capex as business profits recover. Employment will lead this trend as the cheapest means of raising production. Inevitably, as credit markets re-price, there will be turbulence, but this will be advantageous for the financials as a whole.

Indeed, within this sector, higher bond yields and steeper curves will also provide an additional fillip, boosting banks’ revenues from lending. Elsewhere, industrials appear to be positioned strongly with regard to several global trends that are likely to play out over the coming years.

These include the anticipated fiscal splurge on infrastructure in the US, increased pick-up in activity as austerity measures in Europe decline and the continued infrastructure spending and retooling in China – benefiting machinery makers and those European companies with global exposure to new construction. A further driver will also come from rising inflation, enabling industrial and material manufacturers to exercise greater pricing power.

Opportunity will be well spread throughout the market and across a range of market capitalisations. We would see financials start their recovery from the earnings and regulatory crisis of the last 10 years. Exporters will benefit from US dollar strength, both from translation of earnings and transactional competitiveness helping them to grow market share. A general revaluation of the market is probable in the face of the first earnings growth for six years.

Trading range : 30% likelihood

The markets could get ahead of themselves in the first half of the year and then worry about the impact of rising rates in 2018, producing a more choppy, disrupted pattern. We may also find that better growth could lead to the end of quantitative easing and a discussion of a rate rise in Europe and the UK. And as we have seen, the first rate rise is never well received.

Opportunities would be twofold. The euphoria of recovery would continue for at least the first quarter and need to be played before reverting to the long-term growth stocks, which will have been de-rated during this recovery. A distinct shift in the portfolio would occur, around May which will then lead to a lower, but still constructive net. Meanwhile, back in the market, commodity and emerging market stocks may well be under pressure.

Bear market : 15% likelihood

The likely cause of a bear market would undoubtedly be a slowdown in global growth affecting all economies, most probably prompted by a financial crisis in Europe or Asia. Deflationary pressures re-appear, credit spreads widen, a flight to quality and concerns about highly indebted nations being forced out of the euro will accelerate. The response of the fiscal or monetary authorities would fail to initially instil confidence. Politically, there would be a further wave of populism, leading to greater protectionism.

Where would we find opportunity ? We would maintain a low or even negative exposure with a high-net short exposure to weak industrials, cyclicals and financials, expecting major profit warnings in a number of quarters. We would take long positions that are likely to outperform short-cycle businesses. We would be very careful when increasing net exposure, as markets would eventually fall to new lows.

Collapse : 5% likelihood

The bear market outlined above becomes a full-blown crisis of capitalism, with a break down in global trade, a break up of the European Union, protectionist policies, debt default and radical governments. Meanwhile, a loss of confidence in currencies will lead to a dramatic rise in inflation. This is similar to the problems that have been seen in South America, notably Argentina and Venezuela, in the last decade. Opportunities to short will abound and the only long assets will be those in countries where the rule of law and monetary controls continue to operate. It would be a desperate time: equities will fall to levels similar to 1975.