Manager Q&A: Outlook on European Equities
Michael Browne, Portfolio Manager at Martin Currie
Are you expecting a slowdown of the European economy as we are heading into 2019?
I think this is less of a slowdown, more of a cruising speed. If there is to be a slowdown it is more likely to occur this year, as orders slow in the auto industry and last year’s rise in the Euro dollar takes effect. Raw material price rises are also making it tougher for margins in the industrial and manufacturing sectors. At the same time, it is clear that the uncertainty over Brexit is leading to the UK growth grinding to a halt, which as the second largest economy in Europe has an effect. The key longer term is to watch inflation: We think this will settle at 1 to 2% for a long time, within the ECB’s normal range but you cannot justify abnormal interest rates. Rate rises will put some pressure on growth as well. There is upside potential from investment spending, UK bounce back and fiscal loosening especially in Italy.
There is lots of talk about European equities and how valuations look high in some parts of the market as we are entering a time when QE comes to an end. What is your view and where can investors find value?
We are in the mid part of the cycle, when equities rise less than earnings leading to a de-rating. Sectorial leadership changes as excess liquidity ends as rates rise. What has happened this year is somewhat more serious: all the mid cycle issues are bubbling to the surface but alongside fear over Chinese growth, US interest rates, the US cycle ending in 2019 and of course the effect of trade wars. It seems the auto industry is slowing quite fast faced with collapse of diesel car sales and a strengthening currency. All these things combine to lower valuations and there is little end to this in sight. So, the question is when is it right to buy? When will it be cheap enough to buy: after all we don’t think this is the end of the cycle. We will be led by three indicators: 1) technical factors. We use a range of technical and momentum measures to monitor and respond to the state of markets. In January, they became very over-bought. 2) Seasonality: markets have long had a strong summer pattern, with a selloff in June, followed by a rally and then an August fall, testing old lows. We are seeing precisely this pattern in 2018, perhaps more pronounced. 3) the summer sell off is accompanied by earnings downgrades: analysts are always too optimistic at the start of the year and 2018 is no different. We are looking for downgrades in a wide range of sectors but led by retail, industrials and banks. Once these are out, we expect markets to stabilize and focus on 2019, where earnings should grow again. Valuations for P/E’s will be misleading, the earnings downgrades will raise P/E’s even though may have markets fallen. We would focus on Price to Book or Price to cash earnings as better indicators.
With regards to the political situation in Italy, are there attractive investment opportunities at the moment?
We feel that Italy is getting a last chance and perhaps a great opportunity. Any recession in the next few years is going to ensure that the debt/GDP ratio goes well above the current 130% ratio and will provoke a crisis and an EU/IMF bailout. Therefore, during a period of growth, it makes sense for the government to try and spur the economy into life via fiscal measures. Between 5/8% of GDP could be spent, focused on tax cuts and rises in minimum wages. If the multiplier for these tax cuts is greater than 1, We expect debt to GDP to fall decisively towards the 120% level, which might be just low enough to survive the next recession.
Inaction would be a bad sign and although the bond markets may welcome it in the short term, it will mean catastrophe in the next recession and no one wants to see that. Inaction would lead us to downgrade Italian equities and Europe as a whole. We think this is unlikely.
What is your outlook for European equities? Which strategy could investors apply?
The outlook for equities over the next five plus years. The pace of change and new development in the auto industry, the retail industry, banking, packaging, is astonishing. The impact IT will have on healthcare and service provision be it fund managers or road maintenance, or banks will be deep and profound, as will the change in the way we access entertainment and leisure. We are in the midst of a revolution as profound as that occurred 150 years ago when the railways were first built. As a long short manager, it is likely we will see as many short opportunities as long. Not using a long short strategy to invest in Europe today would be to miss the opportunity to benefit from the highs and lows of this monumental change.
Michael Browne is a Portfolio Manager at Martin Currie, a subsidiary of Legg Mason. His opinions are not meant to be viewed as investment advice or a solicitation for investment.
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