European equities: making sense of the unknown

As dust settles on the single worst trading day since the ‘87 crash and regulators implement short sell bans, we wanted to give some colour on what we are thinking and doing.

As investors our job is to try and look at the fundamentals, make some sense of what is happening and to take full advantage of the valuation opportunities the market action creates.

The recent market performance and panic is a function of what some academics call ‘pricing mode uncertainty’. Efficient markets theory works because given certain information the market agrees a clearing price and typically does so based on previous experiences of similar circumstances: a playbook. What makes the current situation so challenging is there’s no obvious playbook and hence the market is struggling to agree to a price.

Last week’s moves were so severe because of a lack of clarity by political and economic leaders on response measures – at a time when the virus had just officially been labelled a pandemic and the media frenzy had intensified. Looking forward, we’d expect to see the foundations being put in place for the market to build from: clarity on the ECB’s position – particularly country spreads, co-ordinated US policy response, and European fiscal responses.

Monetary policy

The ECB announced a number of measures to support the economy – focused on providing ample liquidity and cheap funding. On this last point, the newest TLTRO (III) at a 25bps discount to the -0.5% discount rate means banks can borrow at -0.75% if they are lending to the real economy. All sensible and supportive of the banking system, corporates and households alike.

More important to us is the unanimous decision to leave rates unchanged…it appears ever lower rates isn’t the right answer anymore. According to Lagarde, this is because we’re at the ‘reversal rate’ of interest (where easing is counter growth) which suggests that there is a plan not to keep beating the banking system. Indeed, very clearly and repeatedly, Lagarde called on policymakers to use co-ordinated fiscal tools more aggressively. The pressure is building, and all this could have ramifications for bond-like equities on one side and more pro-cyclical names on the other – assuming volatility does eventually calm down.

Fiscal policy

As regular readers of our work know only too well, we’ve been talking about fiscal levers being used more aggressively for some time. The logic to do so is compelling – not only should it address rising social inequality but could also be a driving force behind a greener Europe. Combating COVID-19 provides another strong reason to be much more proactive. As we are writing this, a Bloomberg headline reads “Germany ready to ditch balanced budget to combat coronavirus”. Is this significant? Yes - they are the key blockade to a more expansionary European wide fiscal policy. Extraordinary events call for similar responses!

Oil stocks

What do we make of the spat between Saudi Arabia and Russia? Near-term, the combined effect of reduced demand due to COVID-19 and a ramp up in supply is a significant headwind: prices have collapsed. A price war was not in our modelling assumptions. Are oil prices likely to remain at these depressed levels forever? At current levels the higher cost producers – e.g. US shale – will need to adjust supply accordingly. Tightening credit markets – a key source of funding for these players – and ESG capital constraints puts even more pressure on finances than previous pressure points have.

Gradually over time this should see some supply discipline return to the industry. Until then it’s going to be tough for the European Integrated companies, but we would expect them to respond aggressively to these headwinds. Acknowledging the lack of clarity in the short term, we made a strategic plan over the weekend and reduced our oil exposure – preferring to consolidate our holdings those players with the strongest individual models based around balance sheet, operating models, management quality and capital allocation.

Opportunities

As a consequence of these events markets have moved aggressively in both magnitude and speed. Shares across the market have de-rated strongly as they anticipate earnings downside. How big the earnings cuts are depend on how severe and long the overhang persists. In the meantime, volatility remains elevated and the market is in panic mode.

At times like these, painful times, the opportunity set for our funds goes up, not down. An example could be Ryanair, held across a number of portfolios, with shares obviously hurting from the responses to COVID-19 in Europe. However, whilst the short-term impacts are significant, we believe the company has the balance sheet to charter these difficult times – good asset backing as they own their fleet, as well having a flexible cost model. Other EU regional airlines are not so lucky, with many airlines hardly profitable in good times, funding themselves through negative working capital.

Similar share price reactions are happening across the market, creating opportunities to buy what we consider to be high returning, sustainable businesses with structural growth opportunities. For now, we are closely monitoring the names we own and some we don’t to take full advantage of the inevitable opportunities. The art is getting the timing right.