Where do you see the risks in European equities?
The focus is on recession and the type of recessionary landing ahead – hard or soft – plus where interest rates are likely to go. Both issues will have an impact on all markets, not just European equities.
Addressing the recessionary concerns first, European macro data and company reports have shown manufacturing has been hit hardest by recent economic weakness including severe cyclical destocking. But the services and consumer side have been far more resilient helped by high employment, wage growth, strong savings and pent-up demand.
This division in the economy has been reflected in share prices with upstream companies, such as manufacturing, experiencing cuts to earnings and valuations de-rating accordingly – in some instances, hits to numbers have been larger than those seen in 2009. Meanwhile, services companies in consumer-facing areas earnings have remained strong; valuation metrics are still quite high relative to history.
Should we experience a ‘soft’ landing, then we would expect those manufacturing, upstream areas to rebound, both operationally and so in terms of valuations – they were the first into the recession and we believe they will be first out in this scenario. In a ‘hard’ landing scenario, we think the downside to the cyclical parts of the market will be more limited, given the extreme cuts already forecast. Conversely for the services and consumer-exposed end, the downside and valuation risk would be significant.Across our European strategy, our cyclical exposure is more towards manufacturing and industrials and we’re avoiding those consumer-facing and services names where there are both cyclical and valuation risk.
Returning to interest rates, we believe that we are unlikely to return to the interest rate lows that we experienced in the decade post the GFC. Unemployment is low, wages are still growing, and inflation remains above trend. We think the risk is that interest rates will stay higher for longer – the ‘Table Mountain’ versus ‘Matterhorn’ view. Growth stocks – or long duration names – in sectors such as technology, which have enjoyed the benefits of low interest rates for the past decade or so, using this environment to fund their expansion and support their valuation multiples. This sector may struggle to continue to dominate performance.