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Europe's ongoing recovery offers investment opportunities

We examine a range of funds that can help investors capture the region's future growth
November 16, 2017

After languishing in the doldrums for several years, European markets have been one of this year's surprise top performers, with the Euro Stoxx 50 index rising 23.5 per cent in the past year. After political risks earlier this year failed to materialise investors have become more optimistic about the continent's prospects. In September, European equity was the second best-selling fund sector, with net retail sales of £518m, according to the Investment Association (IA). And with economic growth picking up across the eurozone and unemployment at the lowest level since 2009, Europe's growth outlook looks more positive than for many years.

Monetary policy in the eurozone continues to be supportive of growth and financial markets. Low interest rates and quantitative easing by the European Central Bank (ECB) are keeping financial conditions loose, and last month the ECB decided to extend its bond buying programme until at least September 2018. However it will start cutting the amount it buys each month from €60bn (£53.42bn) to €30bn from January 2018.

European companies, meanwhile, have demonstrated strong earnings growth on the back of the economic recovery and this could continue into next year.

"The renewed confidence is feeding through to corporates. Mergers and acquisitions have picked up, initial public offerings continue to come to market, and investment decisions are being made," says James Rutherford chief investment officer, European equities at Hermes Investment Management. "After a decade when Stoxx 600 earnings have declined, 2017 is set to break that trend and deliver double-digit earnings growth. Estimates for 2018 are rapidly changing, but current consensus is around 8 per cent growth."

And compared with developed markets such as the UK and the US, Europe is earlier in the economic recovery cycle, which means its performance could have further to run. "This phase is a good place to be as you have the recovery of earnings and earnings growth, whereas the US, for example, is in the later growth phase," says Adrian Lowcock, investment director at Architas. "That's also a reason why European company valuations are at a discount to the US, as Europe still has to pick up that growth."

Even though European equities' valuations are not as cheap as they were after their good run they still look better value than other developed equity markets, particularly the US. At the end of September the cyclically adjusted price/earnings (PE) ratio of the MSCI Europe ex UK index, using trailing 10-year average inflation adjusted earnings, was 18.8 versus a long-term average of 19.3. This is in contrast to the S&P 500's cyclically adjusted PE, using trailing 10-year average inflation adjusted earnings, of 30.7 versus a long-term average of 16.8.

Europe has long been one of the preferred markets for client portfolios for Jason Hollands, managing director at Tilney Group. "Valuations are not the bargain basement they were, but Europe's underlying growth outlook has improved and remains a positive," he explains. "Europe is also well placed to benefit from the broader global recovery as the make-up of European stock markets includes lots of cyclical businesses, which should do well if we continue to see expansion across the globe."

Car manufacturers, financial services companies, and oil and gas producers, which are well represented on European stock markets, are likely to perform strongly in this scenario. 

A potential, if higher risk, opportunity could lie in Europe's banking sector as a result of the improving economic and financial conditions. David Stubbs, head of client investment strategy for Europe, the middle east and Africa (EMEA) at JP Morgan Private Bank, says: "European banks suffered stability issues in the recession of 2012 owing to a burden of bad debt, but there are now opportunities for attractive returns from investments in both equity and fixed-income securities. Share price volatility, cash flow returns and the ability to increase market share are all themes likely to continue to drive the dispersion of asset returns in this sector."

Smaller companies are another area that may continue to do well if the eurozone economy maintains its growth. "When markets are strong, smaller companies tend to outperform, so if you're really bullish on Europe's growth prospects you might want to consider them," says Darius McDermott, managing director of research company FundCalibre.

Smaller company earnings are expected to grow 19 per cent in 2017 and 18 per cent in 2018, compared with 13 per cent and 10 per cent for large-cap earnings in those years, according to Jamie Carter, manager of the SWMC Small-Cap European Fund (IE00B4361X23). 

 

Can Europe's momentum continue?

But others are cautious about Europe's banking system because of the level of non-performing loans.

"We are concerned about investing new money in Europe," says Mona Shah, head of collectives research at Rathbones. "There are a few pockets of value remaining, such as financials and small/mid-caps, and they are decidedly high risk. With the high proportion of financials in the Euro Stoxx 50 index – 22 per cent [of the index] – we are concerned about investing passively in Europe."

Recent short-term credit and monetary indicators may indicate a slowdown in growth. "We're not talking about these indicators going back to recessionary levels, but the key point is that they have stopped accelerating, which suggests the best [growth] is behind us, especially as economic and market performance tend to go together," explains Ed Smith, head of asset allocation at Rathbones.

A stronger euro could act as a headwind going forward. The euro has rallied strongly against many currencies this year, and if it were to strengthen further this could negatively impact the competitiveness of European companies that export goods and services beyond the region.

"The strong euro will undoubtedly become a headwind for earnings and there has been a trend of analyst downgrades over the past few weeks for companies that make a significant proportion of their earnings in US dollars," says Tim Stevenson, manager of Henderson Eurotrust (HNE).

But he adds that while company earnings in 2018 may struggle to replicate those made in 2017, there are still some sectors, like financials, where earnings may remain strong into next year.

Even though the political risks investors were most worried about earlier this year, such as far right candidate Marine Le Pen winning the French Presidential election, failed to materialise, problems remain.

"Going into 2018 there's a bit of complacency about European politics," says Bill McQuaker, manager of the Fidelity Multi Asset Open funds. "At the beginning of this year, everyone was afraid and that was influencing people's attitudes. A lot of the performance we've seen came after the French election as the market priced out [political] risks, but I don't think there's any fear priced in now and the market may need to price that in."

The outcome of the UK and European Union's Brexit negotiations is unclear, and if the Eurosceptic Five Star Movement gains ground in Italian elections next year this might also have a detrimental effect on markets. The Catalonia crisis, meanwhile, could have an adverse knock-on effect on wider eurozone economies and put considerable pressure on the euro.

"In the short term there will be ongoing and increasing uncertainty, which is likely to create turbulence in domestic and regional financial markets," says Nigel Green, chief executive of financial consultancy deVere Group. "In the longer term, if Catalonia splits, Spain's economy – Europe's fourth-largest – could lose 20 per cent of its revenue. Plus the process could adversely affect investment into both Spain and Catalonia."

The ECB will also need to tread a careful path. Nancy Curtin, chief investment officer at Close Brothers Asset Management, says: "[The ECB's] slow, steady and widely predicted approach hopes to rein in the euro from rising further, which is limiting the earnings capacity of European exporters, at the same time as avoiding a European taper tantrum in the markets. Whether one can be achieved without the other remains to be seen."

 

Funds to capture Europe's recovery

Jupiter European (GB00B5STJW84), which we count among the  IC Top 100 Funds, is one of the best performing funds in the IA Europe excluding UK sector.

"This is a high-conviction, unconstrained fund that backs businesses with proven products, above-average growth prospects and high barriers to competition," says Mr Hollands. "The longer-term record since Alex Darwall began managing the fund in 2001 has been stellar."

Another fund that consistently performs well is BlackRock European Dynamic (GB00BCZRNN30). This is among the 10 best performing funds in the IA Europe ex UK sector over one, three and five years. The fund has been managed by Alister Hibbert since 2008 and has a capital growth objective. It invests in companies that Mr Hibbert considers undervalued or have good growth potential.

"The manager can take a value or growth approach and the fund benefits from the flexible, unconstrained style which means that it can adapt to changing market conditions," says Mr Lowcock. "The manager combines fundamental stockpicking with macroeconomic awareness."

Relative to FTSE World Europe ex UK index, the fund is overweight Scandinavian countries such as Denmark. 

BlackRock European Dynamic geographic allocation as at 31 October 2017 (%)
CountryFundFTSE World Europe ex UK index
France19.4121.78
Switzerland14.7817.26
Germany14.5720.71
Denmark12.083.81
Netherlands9.797.36
Sweden5.986.23
UK4.90
Spain3.967.22
Finland3.772.16
Belgium3.492.57
Italy3.15.62
Ireland1.590.54
Cash/derivatives2.580
Source: BlackRock

BlackRock European Dynamic sector allocation as at 31 October 2017 (%)

SectorFundFTSE World Europe ex UK index
Industrials27.515.7
Consumer goods19.0519.29
Health care14.2812.07
Consumer services12.534.71
Technology12.225.03
Financials11.323.11
Oil & gas0.534.32

Source: BlackRock

Mr Hollands rates Threadneedle European Select Fund (GB00B8BC5H23), which is managed by Dave Dudding and Mark Nichols. It aims to achieve above-average capital growth from a relatively concentrated portfolio of companies domiciled in continental Europe, or which have significant continental European operations.

"The fund has a buy-and-hold approach focused on quality growth companies with an emphasis on strong brands such as L'Oreal (OR:PAR) and Richemont (CFR:VTX)," says Mr Hollands. "The managers like companies with very strong brands, which can generate their own secular growth, and the fund tends to have quite a lot of consumer exposure."

The fund is in the second quartile of the IA Europe ex UK sector in terms of performance over one, three and five years, but beats the sector average over these periods.

Although Ms Shah is cautious about investing in Europe she likes FP CRUX European Special Situations Fund (GB00BTJRQ064), which we also count among the IC Top 100 Funds.

"[This] is a style-agnostic European equity fund, which is also benchmark-agnostic," she explains. "It tends to trade on a lower valuation multiple to the index and exhibits defensive properties in falling markets. Its manager, Richard Pease, is undoubtedly one of the most talented in this sector and has over 30 years of investment experience."

Smaller companies funds

Ms Shah also likes JPMorgan European Smaller Companies Trust (JESC), which was trading at a 6.6 per cent discount to net asset value (NAV) as of 9 November, considerably tighter than its 12-month average of 11.3 per cent. The trust has performed strongly with a share price return of 220 per cent over five years.

"As you go down the market cap spectrum you can gain more exposure to domestic earnings rather than, for example, earnings from the US, Asia or emerging markets," says Ms Shah. "This trust is underweight financials, and overweight technology and industrials, two areas that we like. It's also very liquid, with a market cap of over £650m."

Another good way to access European smaller companies is T. Rowe Price European Smaller Companies Equity (LU1028171921), according to Mr McDermott. This fund aims for long-term capital appreciation by investing in companies incorporated in, or which conduct the predominant part of their business activity in, Europe and whose market capitalisation is typically below the range covered by the S&P Pan Europe Small Cap Index. The fund's manager, Ben Griffiths, has only been running the fund since January 2016, but since then performance has been good. The fund has returned 37.7 per cent over one year, outperforming MSCI Europe Small Cap Index's 25.3 per cent.

Fund performance

Fund/benchmark1-year share price/total return (%)3-year cumulative share price/total return (%)5-year cumulative share price/total return (%)Yield (%)Ongoing charge (%)
BlackRock Continental Europe Income21.657.5124.83.630.93
Invesco Perpetual European Equity Income 23.450.8na2.980.89
BlackRock European Dynamic 31.471.7na0.630.92
Jupiter European 30.071.3129.60.41.03
T. Rowe Price European Smaller Companies Equity37.795.7155.10.01.12
Schroder European Alpha Income24.366.1151.02.670.92
FP CRUX European Special Situations23.172.0125.31.450.86
Threadneedle European Select22.855.9103.70.950.83
JPMorgan European Smaller Companies45.7119.7219.11.21.13*
Henderson EuroTrust 26.170.0128.02.10.87*
IA Europe excluding UK sector average22.955.1103.3  
IA European Smaller Companies sector average28.077.4134.6  
AIC European Smaller Companies sector average46.6109.0200.3  
AIC Europe sector average32.055.8130.0  
FTSE World Europe excluding UK index22.551.999.8  
MSCI Europe Small Cap index25.373.6142.9  
Source: Morningstar, *Association of Investment Companies 
Performance data as at 09/11/17

Funds to capture Europe's income

Gary Potter, co-head of the F&C multi-manager team at BMO Global Asset Management, invests in BlackRock Continental European Income (GB00B3Y7MQ71) because of its focus on quality companies. This fund is in the first quartile of the IA Europe ex UK sector over five years in terms of performance, as well as offering a yield of 3.63 per cent.

The fund aims for an above-average income compared to the income yield of European equity markets without sacrificing long-term capital growth. 

Mr Potter also holds Schroder European Alpha Income (GB00B7FHV230). Its manager, James Sym, shifts its holdings between cyclical and defensive, and between value, quality and growth companies, depending on what he considers to be the prevailing market conditions. He typically holds between 30 and 50 large or mid-sized companies that he hopes will offer 50 to 100 per cent upside over the next three years.

"James Sym can't be classified as a pure growth or value investor," says Mr Potter. "Good managers react to share price movements and I think that pragmatic style is a positive thing in this environment."

Mr McQuaker holds Invesco Perpetual European Equity Income Fund (GB00BJ04G396) in the funds he runs. Invesco Perpetual European Equity Income aims for a rising level of income with long-term capital growth.

"The fund has a value-driven approach and exposure," says Mr McQuaker. "Over most of the past 10 years it has been quite a struggle to make the value style work as it has been out of favour. But manager Stephanie Butcher has proved that she's adept at making that valuation approach work better than most. The strategy has got quite a lot of exposure to oil companies and banks, which should do well if the global expansion continues. If we get policy adjustment, higher bond yields would be a very welcome development for the banks and financials in the portfolio."

This fund is among the top 10 best performers in the IA Europe ex UK sector over five years, but its 12-month yield is lower than some of its income-focused peers at less than 3 per cent.

Invesco Perpetual European Equity Income sector allocation as at 29 September 2017 (%)

Financials27.11
Industrials17.56
Oil & gas12.48
Health care9.48
Telecommunications9.39
Consumer services6.99
Basic Materials6.65
Consumer Goods5.07
Technology3.3
Utilities1.64
Other0.32
Source: Invesco Perpetual