European Equities: Q&A with Oliver Collin

A Q&A with Fund Manager, Oliver Collin. Discussed topics include:

• Monetary and fiscal policy responses in Europe
• Thoughts on European banks and insurers
• What the recent wave of dividend cuts means for income investors
• New opportunities that the recent sell-off / volatility has provided

Have you been impressed by the policy response by the European authorities to this crisis? How does the monetary and fiscal efforts compare to its history and actions taken in the US?

COVID-19 meant a global lockdown, which in practice means an unprecedented demand and supply shock. Working to c2.5% GDP per month and min two months of full lock-down then gradual re-opening then it’s fair to assume GDP contraction of at least high single digit. That level of economic contraction means we needed a significant policy response. The good news is we’ve got one and it looks to be fit for purpose as measured by size and scope. People are perhaps too blasé about the monetary response because we’ve become so used to Quantitative Easing post the GFC, and maybe because of poor initial communication at early stages by President Lagarde at the ECB. I am more sanguine given the speed of response - people forget the ECB actually raised rates 2 months before Lehman collapsed and many of the structures needed for outright monetary transactions, centralised banking regulation and QE didn’t exist until 3-4 years after the banking crisis began.

In 2020, we had an immediate initiation of the E750bn Pandemic Emergency Purchase Plan with no capital key and no purchasing limits. At the latest ECB meeting, they’ve increased that by a further E600bn, as well as increasing the duration - exceeding the most bullish of expectations. We’ve seen TLTROs put in place enabling banks to borrow at up to -100bps (i.e. paid to borrow), and we’ve seen that the banking system has strong capital positions going into the crisis (unlike the GFC) and be granted counter cyclical forbearance – exactly as designed.

Apart from the monetary response, we’ve also seen a change in fiscal stance. Post GFC the fiscal response was austerity but as the severity of Covid-19 and lockdowns became evident, so Europe has done a complete volte-face with a combination of fiscal stimulus, furlough labour schemes and credit guarantees. The measures are tens of percentage of points of national GDPs and means capital is not automatically destroyed by the lockdown. The next stage is European vs National response with measures such as the E100bn SURE initiative to protect short-time workers or E200bn EIB emergency liquidity support got SMEs ad the most recent E750bn EU Recovery Fund.

I guess putting that all together means that I am “impressed” by the European response

Do you think markets have been impressed? It’s not obvious they are, and what is the basis for scepticism?

I think it’s clear the market’s response has been unimpressed with the EU response. European equity flows have remained negative and the equity risk premium has touched nearly 8%, vs US at 5+%. I think the scepticism comes from QE not leading to growth in the last decade so there’s an element of “who cares?” and re the fiscal response the feeling was “here we go again”, whereby Europe needs a full blown Euro crisis to enact change so fiscal was a pipedream. I think seeing the Franco German alliance for E500bn package and then the European Commission taking that at raising it to E750bn with a Green wrapper to appease the frugal 4/Nordic countries has meant the market is beginning to believe it may be real.

Banks seem to be a decent measure of investor sentiment toward Europe’s prospects - there doesn’t appear to be much prospect for margin expansion and the loan book looks a little vulnerable. Yes, they are looking cheap, but is valuation enough?

Firstly, unlike the previous global financial crisis, banks are not at the epicentre – they are not the cause.

Secondly, as mentioned the banks have gone into this crisis with a stronger capital position - up to 3 times as high, more diversified business models having added more fee-based business i.e. wealth management and insurance products given they’ve not had a yield curve to trade. They’ve also de-risked the asset side of their balance sheets through improved risk management.

I think the problem for bank equity is partly Pavlovian in that investors are looking at the GFC as a crisis playbook and making the wrong conclusion that NPLs will explode and equity issuance is inevitable – because of lending criteria, capital positions and government guarantees, we don’t see that. Also, I think the regulator was wrong to suspend banks dividends given it created additional unnecessary uncertainty at a time the sector has few friends.

We don’t believe NPLs will rise uncontrollably, and hence we think banks will not need to raise equity and dividends will be reinstated in time...if our view holds true then the sector trading on around 0.4x P/BV has the potential to be a significant source of alpha.

Banks are meaningful allocation in your portfolios, as is Insurance – what are your thoughts on how each sector has performed into and post the crisis...and how do you explain this?

We had reduced our Insurance exposure throughout 2019 as the sector appeared to decouple from the rate environment and there were risks related to rising claims – particularly in the USA from social inflation. Having a lower weight into the COVID crisis meant we’ve been able to buy-back quality insurance assets as they sold-off aggressively as the crisis unfolded: companies such as Munich Re or Ageas or add to existing holdings such as Axa at very attractive levels.

The saying goes, banks lend and hope for the best and insurers insure and then plan for the worst. Add to that Insurance analysts are typically like Eeyore in character – or put politely they are prudent, and you start to understand why the shares have underperformed the market. The big technical issue in the wake of the pandemic for the insurance sector is lack of clarity for business interruption risk for 2019. We see this as a purely 1x PE earnings event given the sector has great solvency capital – it can absorb the losses – and the price on the other side of COVID is rising demand and hardening prices.

I should also mention the EU insurance regulator’s recommendation to suspend dividends. If the EBA’s decision was prudent, EIOPA’s was just wrong best reflected by the likes of German regulator BAFIN not endorsing it and dividends being allowed. We expect th EU in majority of insurance dividends to be reinstated asap.

Thinking about income in general, we’ve seen big dividend cuts/suspensions across the board. Should we no longer consider income investing as a defensive strategy?

Simple answer is no. The truth is European income cuts are ‘less bad’ than perhaps headlines suggest. Banks are 15% of the index but pharma is >11%. Unlike the UK market the EU index isn’t dominated by Energy (only 6%).

The biggest issue for 2019 dividends, paid in 2020, for EU companies has been the timing of the crisis. EU dividends are typically paid annually and hence c75% are paid in April-June which is when COVID has caused peak disruption to both the businesses and the required AGMs to approve them. A number of companies, some of which we own, have suspended their dividends on practical, not financial reasons and therefore will be paid.

What opportunities stand out to you?

What’s perhaps most different about COVID-19 to other crises is how all companies have been impacted almost equally. Whether Services, Consumer plays or Industrial cyclicals, business models have been severely affected and management teams challenged.

Our sense is the companies in the more cyclical and financial areas of the economy have perhaps more experience of how to deal with such a crisis. Volvo had a near death experience post GFC and its current management team managed the Scania trucks business expertly – that experience creates muscle memory at times like these. Other, traditionally more resilient, businesses may not have that experience and it perhaps makes decision making slower.

The same is true for the financial markets where both the buy and sell side apply the GFC playbooks to companies and hence cyclicals see earnings cut heavily and immediately – the numbers are de-risked. Some of the more defensive areas of the market might be more at risk of repeated cuts vs the big bang approach as the playbook is less clear.

When we add this framework to the market multiples whereby cyclicality is cheap vs defensiveness expensive, then we feel we are being paid to take the cyclical risk right here and now. There is a caveat though – we only want the cyclical risk and not the balance sheet risk and so are being more balance sheet disciplined.

Any other opportunities that stand out to you?

Maybe one last comment to make outside of the cyclical area that we find attractive is telecoms. The sector is inherently acyclical in nature thereby providing some earnings support, all the while offering great value and income potential despite the burden of 5G capex. The market doesn’t like the telco sector given 10 years of regulatory pressures - roaming charges or termination rates – and an obsession with 4 operator market. We believe the regulatory pressures have been abating for some time and perhaps we’ve all realised when we’re working from home that the quality of service is at least as important as price – it was interesting to see the last month’s decision by the ECJ to overturn the blocking of the merger between O2 and EE back in 2016. That merger would have consolidated the UK telecom market from 4 to 3.