Rory Bateman, Head of UK & European Equities: 16 Oct 2014
There has been a substantial increase in volatility over recent weeks caused by a number of different factors which have significantly impacted investor sentiment. European equities have declined by almost 15% since mid-September and we would like to highlight this setback as a buying opportunity.
Recent economic data from the eurozone has undoubtedly disappointed versus expectations and the chances of a recession have increased. However, downward revisions to economic activity have not been sufficiently large to justify the scale of the selloff. This suggests to us that the plethora of other issues out there in the market place are having a disproportionate impact, which from our perspective offers an interesting entry point for those investors waiting for an opportunity.
If we look at the economic fundamentals in Europe, the main concern that low levels of inflation may turn into deflation is not new and in our view there is little evidence to suggest that the chances of deflation have increased. Whilst consensus GDP forecasts have been reduced moderately, leading indicators remain positive and inflation expectations have barely moved. European Central Bank (ECB) President Draghi has announced a number of measures to try to ease credit conditions in the eurozone but these have yet to be fully implemented, at least in part due to the ‘asset quality review’ (AQR) and stress tests being carried out on the banks. The results of the AQR will be known very soon which should give the banks more confidence to lend and to get on with their day-to-day activities rather than worrying about their capital positions.
Furthermore, we believe that if the deflationary forces become too significant there is a high probability of full scale quantitative easing (QE) in Europe. The significance of QE for European equities should be seen in the context of the US experience. The S&P500 saw strong upwards momentum during QE1, QE2 and QE3. Immediately after QE1 and QE2 the S&P saw a correction as liquidity was withdrawn from the system. This is precisely what we are seeing today with the suspension of QE3 earlier this month.
Of course, there are a number of other factors currently having a negative impact on sentiment. It’s impossible to assess the ultimate impact of the Ebola virus, but history tells us that the markets are usually very quick to react. Governments inevitably respond to the human tragedy and this response is intensified when the threat of global destabilisation enters the arena. It’s inappropriate to compare the severity of current versus historic epidemics or pandemics, but what we do know is that recent evidence suggests containment can be achieved when there is a unified global response. Screening of arrivals has now started at Heathrow International Airport in a bid to control the risk of the virus entering the UK.
Another cause for concern has been the 25% decline in the oil price. There are both demand and supply dynamics at play here. On the demand side, a concurrent slowdown in Europe and China is inevitably reducing demand for barrels. On the supply side, the structural shift in the US towards self-sufficiency is bound to have an impact on an industry that has been dominated by a cartel. OPEC has decided to try to squeeze the US shale producers to ensure a long-term continuation of the cartel. From an equity market perspective, input costs for numerous industries have just improved dramatically. Take the travel industry, for example, where in a normal environment profitability would be improved significantly by lower oil prices but fears of collapsing travel demand given Ebola have steered investors away from this area of the market.
The pharmaceuticals sector in recent months has been buoyed by the potential M&A benefits of so-called US ‘tax-inversion’. The probable withdrawal of the AbbVie bid for Shire shows how reticent the US authorities are to allow US companies to benefit from deals structured around tax savings. The repercussions of the US stance on this issue is temporary as some share prices inevitably adjust.
We are not suggesting there are no risks on the horizon, merely that a number of the negative influences driving sentiment during the current selloff are temporary in nature which for long-term investors can create opportunities.
We would like to finish by delivering a message to investors and authorities alike. Your view and interpretation of this message may well determine whether or not allocating capital to Europe makes sense for you as an investor. The message is that it’s time for Germany to step up. Mario Draghi is in the process of utilising all the power he has as ECB President with monetary stimuli, namely TLTRO, ABS purchases and probably full scale QE at some point. However, on a number of occasions he has also highlighted the fact that monetary policy cannot create a sustained recovery in Europe without governments, where possible, taking appropriate fiscal measures. The German insistence on balancing the budget is highly commendable but not at the expense of ignoring the economic cycle and ignoring the fact that they are the key member of the eurozone itself.
Our belief is that the recovery in Europe will be slow and bumpy. Germany needs to act to ensure that recovery is sustainable and to take responsibility for the survival of the eurozone.
Red IFA: You can contact us through the website if you would like to talk to one of our Independent Financial Advisers.