European equities – 2020 outlook

Key takeaways
Signs of better than expected economic data ahead
Growing debate on the merits of a more generous fiscal policy
our stock analysis has led us to favour the ‘Value’ end of the market going into 2020

At the time of writing, European markets have rallied by some 20% year to date. It would be very easy to assume markets are at multi-year highs, however, in reality we have only just marginally surpassed levels seen at the beginning of 2018. As we envisaged at the start of the year, markets have recouped much of the prior year’s losses following the reversal of several one-off issues and some easing of sentiment.

However, what has worked within the market for much of this year, has been very different to what we had hoped for. Headline performance has masked wide variations between factors within – there have been clear winners and losers and stock valuations have also become increasingly bifurcated.

Figure 1: Relative performance of European Growth, Quality and Value stocks
Figure 1: Relative performance of European Growth, Quality and Value stocks
Source: Datastream, 23 October 2019. Indexed to 100 on 1 January using MSCI Europe universe.

Sluggish European macro data (we see the glass as half full, most people see it as half empty), worsening Trumpian trade uncertainties and, for good measure, a couple of volte-faces from central banks have all fed the unprecedented rally in bond markets this year. Equity markets have generally been dancing to the bond markets’ tune.

‘Bond proxy’ stocks and sectors perceived as traditionally ‘safe’ have been the ‘haves’, whilst the ‘have-nots’ have been economically-sensitive parts of the market which have been left behind. In valuation terms, the divergence between ‘Quality’ and ‘Value’ has surpassed levels last witnessed during the TMT crisis and Global Financial Crisis. Equally, at a stock level there are plenty of examples of outperformance being driven by re-rating rather than fundamentals alone. The market’s sometimes lazy analysis is to assume that ‘Quality’ / ’Growth’ stocks have a monopoly on quality business models. We know that this is simply not the case.

Figure 2: History shows when 'quality' becomes quite this stretched against 'value' starts to outperform
Figure 2: History shows when 'quality' becomes quite this stretched against 'value' starts to outperform
Source: Citi, as at 30 September 2019. Chart shows P/E relative of Long Quality vs Long Value. Current P/E relative = 2.56. Value factor calculated using equal weights: Earnings Yield (12m fwd and 12m historical), Cash Flow to Price, Book to Price, EBITDA / EV, Dividend Yield, Sales to Price, Sales / EV. Quality factor calculated using equal weights: Earnings Certainty, Net Profit Margin on sales, Earnings Quality (accruals, inverted), Return on Equity, Margin Growth, Balance Sheet Quality. Factor valuation is the P/E relative of top quintile/high quality versus top quintile/cheap value from MSCI Europe ex UK Index.

What could change in 2020?

Better than expected economic data:

  • There are reasons to be cheerful. Looking at the Eurozone we see a number of drags on data which are now disappearing or lessening, meaning that 2020 may even surprise positively, undermining ‘bond proxy’ style equities in the process.
  • We look to be coming to the end of a meaningful destocking phase in the inventory cycle. After multiple hits from global trade tensions, Brexit and the auto sector, export-led Germany should see some respite. Indeed, German manufacturing new orders seem to be bouncing and European PMI surveys are stabilising.
  • A similar picture can be found in Asia, which often works as a leading indicator for Europe.
  • Meanwhile, the domestic picture is set to remain fairly robust throughout 2020 with positive signs emerging from continued bank lending growth and rising wages.
Figure 3: % Y/Y Private Sector Loan Growth by Loan type
Figure 3: % Y/Y Private Sector Loan Growth by Loan type
Source LHC: Morgan Stanley, European Central Bank. As at 19 November 2019.
Figure 4: Eurozone core inflation and wage growth (% yoy)
Figure 4: Eurozone core inflation and wage growth (% yoy)
Source RHC: Datastream, Invesco as at 18 November 2019 (using latest Q3 available data).

Less monetary, more fiscal:

  • Since the Global Financial Crisis, policy making has relied almost entirely on monetary policy. With the emphasis on reducing budget deficits, expansionary fiscal policy was regarded as impossible. Judging by how conservatively markets are positioned (despite some of the most recent sector rotation moves), a change in fiscal spending and investment is still far from being investors’ base case.
  • However, we do not think that the growing chorus and vocal debate about the merits of more generous fiscal policy which has started this year looks likely to go away any time soon. Christine Lagarde, now at the helm of the ECB has been very forthright. Likewise, the message coming from the European Commission too.
  • We now see many examples of National governments acting to exploit their strongest finances and cheap funding to boost the fiscal impulse in 2020: a silver lining to the cloud of populism?
  • Let’s also see if the entirely consensual view of no change from the ECB – despite new management – turns out to be correct. One should not forget that former president Draghi’s final wave of stimulus was not supported by a sizeable element of the governing council.

Beware of wolves in sheep’s clothing

Cracks are already starting to appear in some of the stocks which have benefited most from a decade of extremely accommodative monetary policy. Where does that leave us in terms of fund positioning as we go into 2020? We understand the logic of buying ‘duration assets’ if bond yields only ever fall, but as we have seen very recently, bond yields can also rise – and ‘duration assets’ has better turn out to be ‘durable’ or else the consensus in the market really do have problem.

Any recent examples? There have been negative regulatory reviews undermining the dividend growth capacity, and therefore the bond proxy status of some utilities. Certain consumer staples stocks and luxury goods companies have been seeing negative earnings revisions and subsequently their share prices have struggled. We are not saying that all ‘Quality’ stocks are disappointing, but rather that the list of poor performers is now long enough to discern a trend – a trend which can very easily continue into 2020.

To our minds, a far better risk reward balance can be found in sectors well away from the market’s focus. This is a similar message to the one we gave a year ago, but the logic is still intact, if not actually stronger today. Given the valuation argument is even more powerful now, it is then worth remembering that in Europe for long-term investors there is a strong correlation between the price you pay for assets and the returns you get.

‘Value’ stocks are in aggregate no longer front and centre in terms of earnings disappointments: indeed, earnings trends are currently stronger at the ‘Value’ end of the market than at the ‘Quality’ end of the spectrum. Macro-economic trends – and the policy making balance – also seems to have turned a corner. For 2020, we see an interesting combination of still loose monetary policy and supportive fiscal trends. To us, this sounds ‘economic growth friendly’ and ‘Growth stock unfriendly’.

We remain valuation focused in our stock analysis and that has led us to favour the ‘Value’ end of the market still going into 2020. We find a sufficiently diverse range of opportunities – industrial, cyclical, financial, defensive – at that end of the stock market to construct portfolios which we believe can offer our investors a very differentiated take on how to make money in Europe.

Daring to be different can ‘pay dividends’ – both literally and metaphorically!

Read more 2020 investment outlooks

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