Look beyond poisonous politics for hidden opportunities in Europe

"But companies are not the economy or politics of any nation," says Martin Todd, co-manager of Hermes European Alpha Equity Fund (IE00B3RFR850). "Although European businesses may operate within these overarching forces, many have the talent, resources and opportunities to adapt, restructure and innovate in order to thrive."

European companies that are performing strongly have proved their resilience, having endured eight years of economic and political turbulence. Even without an economic tailwind companies such as Madrid-based IT solutions provider Amadeus (AMS:MCE) have been growing by improving efficiency and reducing costs through new technology, says Mr Todd.

And the economic backdrop is starting to improve. Unemployment has fallen across the eurozone to 9.6 per cent, the lowest since May 2009. The region grew by 0.5 per cent in the last quarter of 2016, up on the previous quarter, suggesting the recovery is picking up pace. January's eurozone PMI manufacturing survey was also at its highest level since 2011, at 54.4. However inflation rose to 1.8 per cent in January, the highest in almost four years.

"These latest growth figures are another positive sign for the eurozone, despite much of the negative sentiment surrounding the continent," says Nathan Sweeney, senior investment manager at Architas. "If you were to remove the political instability you would be left with a region that is undergoing a real recovery, with unemployment coming down, albeit slowly, inflation picking up and growth firming. It was not so long ago that the investment world was concerned about deflation in the eurozone and negative bond yields were widely accepted. This is no longer the case."

The impact of policies pursued in the US could spur higher inflation and interest rate rises there, but also positively boost European financials and infrastructure companies operating globally.

"History shows that European equities perform better when growth and inflation expectations rise globally," says Jaisal Pastakia, investment manager at Heartwood Investment Management. "First, European companies derive 50 per cent of their sales outside Europe. Second and more crucially, these companies tend to have a higher fixed cost base and are therefore more sensitive to changes in sales, meaning they should benefit more on the upside as sales tick up."

Unlike the US, monetary policy in the eurozone continues to be supportive of growth and financial markets. Low interest rates and ongoing quantitative easing (QE) by the European Central Bank (ECB) are keeping financial conditions loose.

"The ECB has done a very good job of breathing some life back into the EU economy," says Bill McQuaker, manager of the Fidelity Multi Asset Open funds. "Looking at the year ahead, I think there will be continued growth and I expect inflation to pick up a little bit, but we won't see enough to cause a reversal of the accommodative policy [the ECB] is following."

The supportive economic backdrop could also boost corporate earnings.

"What might surprise people is the starting point for EU earnings, particularly the contrast between the US and the EU," says Mr McQuaker. "Underlying earnings progression in the US is well above the peak level of earnings in 2007 - by about 20 per cent to 25 per cent - but in Europe we are still some way below what we saw in 2007, and by some estimates not that far above where we were in the 2009 trough."

And the improving economic picture means any small improvement in sales could have a big impact on profits and result in good company earnings.

Mr Pastakia agrees this is a possibility, pointing out that after four consecutive quarters of contraction earnings per share growth turned positive in the third quarter of 2016.

Wealth manager Tilney Group's portfolios are overweight European equities, despite them being cautious on equities generally. "The US equity market looks rich in terms of valuations," explains Jason Hollands, managing director at Tilney Group. "Does it make sense to be using your pounds, which are already at a multiyear low against the dollar, to buy into an already expensive market? If you are going to invest outside the UK why not invest in a region that is also doing well, but where valuations are reasonable and growth is not too bad."

Political risks

France, Germany and the Netherlands are having elections this year, and there may be an early election in Italy. In particular, if far-right National Front candidate Marine Le Pen wins the French presidential election, this may rock markets and cause the euro to fall.

"The political risks are front and centre of investors' minds, in particular in the French election," says Mr McQuaker. "Although the Dutch election comes first, the feeling is that if the more populist party wins in the Netherlands, as it might, it wouldn't win an outright majority. The difference with a Le Pen victory is the possibility of having a referendum on the EU and what that might mean for the euro currency."

He believes the chances of a Le Pen victory are lower than investors expect, though, saying the binary choice in the final round of the French election is likely to work against her. But he adds that investors should not just assume that markets would react unfavourably if Ms Le Pen does win. Despite the political shocks of the Brexit vote and Donald Trump's presidential triumph last year, markets reacted positively.

The impact of the UK leaving the EU and the policies pursued by US President Donald Trump are additional risks for those investing in Europe. EU economies may suffer a loss of business on exports to the UK, depending on the final outcome of the Brexit divorce negotiations and any resultant trade deal. And the Trump administration recently accused Germany of using a weak euro to exploit the US and other EU countries for its own benefit.

Mr McQuaker says: "Donald Trump has been talking about trade and identified the eurozone and Germany in particular as having a high trade surplus that he'd like to see diminish. But there are other countries that have high trade surpluses - such as China and Mexico - which he has also identified. It would be surprising if he placed high tariffs on Germany first - it would be an unusual step to start with a longstanding ally. But even if it happened that [protectionism] would lead to problems for other regions, including the US."

With all the potential political drama and market volatility that might result, the eurozone's central bank will need to tread a careful path. "It's difficult for the ECB because it has to be seen to be supportive as there are so many potential political events that could be negative," says Mr Sweeney. "So it has to maintain that even keel stance on interest rates and continue buying up bonds, and not be seen bending over backwards to suit the German economy, which wants to see rate rises because they're concerned about inflation or their banking sector."

Amaya Assan, senior investment research analyst at investment research company Square Mile, adds: "I'm not saying that in aggregate European equities' valuations are expensive, but given the number of concerns and risks out there neither are they extremely cheap. The thing to focus on is whether earnings growth will continue. We've seen some green shoots and the managers we speak to are broadly constructive on the asset class, but they are looking closely for companies that can maintain margins and pricing power."

Funds for investing in Europe

Ms Assan suggests Artemis European Opportunities (GB00B6WFCR53). "This fund takes a practical, flexible approach which is neither growth nor value, and it is looking to achieve a fairly modest return," she says. "Its managers aim for consistency. They like quality companies and are also quite valuation sensitive, so if you want a fund that is not going to give you a bumpy road, this might be it."

Another option for investors who want European exposure with lower volatility is Threadneedle European Select (GB00B8BC5H23). "The underlying companies the fund holds are robust and reliable businesses in sectors such as manufacturing and healthcare," says Mr McQuaker. "These businesses should provide regularly high [returns] where investors see a steady compounding effect."

Oyster Continental European Selection Fund (LU0995827317) is not very well known, but has so far performed well. "Its manager [Michael Clements] looks to buy quality companies when they are at a good price, typically when they are out of favour," says Ms Assan. "It requires him to do a lot of work to find out if the company is high quality, why it is out of favour and what could go wrong with its business model. The fund could provide you with a bumpy ride because markets are driven by certain themes, but it's good if you want to invest for the longer term."

However, this fund has a relatively high ongoing charge of 1.31 per cent.

Mr McQuaker thinks it's a good idea to blend together different strategies when choosing European equity funds. "One important observation of 2016 was the extraordinary rotation in the market," he says. "The first half of the year was about owning equities that had defensive qualities such as low volatility, low growth and reliability, and the second half was radically different. The desirable options were companies that were cheap or distressed, and that could benefit from a cyclical improvement taking hold."

To get sufficient exposure to these strategies he suggests Invesco Perpetual European Equity Income Fund (GB00BJ04G396). "This is designed to deliver income to investors and usually that means having some kind of valuations discipline at work," he says. "The price of the asset matters to its managers and they also have some exposure to industrials, banks and the energy sector. It's a very well managed strategy."

He also suggests Jupiter European Fund (GB00B5STJW84). "This is a different beast. It focuses on quality growth and has quite a bit in the healthcare sector, which has not been an attractive area of the market. But if we find that political developments in the US relieve some of the pressure on global healthcare, it could perform well."

Jupiter European's manager, Alex Darwall, also runs Jupiter European Opportunities Trust (JEO), which Mr Hollands says is high conviction and is differentiated by having about a third of its portfolio in the UK, against only 5 per cent for the open-ended fund. However this trust has a performance fee, which results in a much higher ongoing charge of 1.88 per cent.

Mr Sweeney thinks that if growth takes off we could see a market switch with investors moving into riskier, more growth-orientated areas such as financials. "BlackRock European Dynamic Fund (GB00BCZRNN30) would do well in that scenario when people are feeling more confident and it's less about balance sheet strength," he says. "Financials, consumer goods and industrials are the three biggest sector exposures in this fund, so with an improvement in the eurozone economy and a pick-up in belief in that region, BlackRock European Dynamic should benefit."

Mr Hollands suggests Henderson European Focus Fund (GB00B54J0L85), which also has a big position in financials of 30 per cent and a strong performance record.

Performance

Source: Morningstar, as at 3/02/17 & *Association of Investment Companies