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- Allocation to European equities is at record lows, sentiment is extremely bearish and valuations have slumped
- A number of positive factors that have been overlooked, including the low debt of corporates and consumers
- Secular trends, such as the energy transition and digitalisation are still in place
At the start of 2022, investors were looking forward to a strong continued recovery in corporate earnings, a normalisation in supply chains and an easing of inflationary pressures after the difficulties of the pandemic. However, the war in Ukraine and the resulting energy crisis, plus rising interest rates, have led to a sell-off in European financial markets amid broad-based fears of an economic slowdown.
Markets have already been characterised by a significant shift from growth to value stocks of a scale not seen since the financial crisis. This has seen some of the best businesses in Europe substantially derated. In our experience, shifts of this size can only be sustained if fundamentals back up those moves in share prices. Over any meaningful time, it is the relative strength of businesses and industries that determine share price performance.
Today, we are in a situation where allocation to European equities is at record lows,1 sentiment is extremely bearish and valuations have slumped. This holds true for some of the best businesses Europe has to offer.
Healthy corporates and consumers
While much of the current debate focuses on when inflation is going to peak and the extent of the recession, there are, we believe, a few positive factors that have been overlooked.
When we speak to companies we hold today, many are not seeing a material slowdown in demand or order books. Their spending intentions also remain in place, often linked to transformation spend, such as digitalisation, reshoring of supply chains or the energy transition.
We believe consumers are in better health than has been suggested, with governments across Europe doing their best to protect households from those severe cost pressures, with measures ranging from capping consumer electricity and gas prices to offering credit and guarantees to power providers at risk of collapse.2 This should provide some cushion for the squeeze in disposable income.
Energy spending
The war in Ukraine has created greater urgency among European politicians to accelerate the energy transition and reduce dependency on imported gas. Europe had been leading the world in its environmental policies. The war may bring forward spending that might otherwise have happened later in the decade.
As investors in Europe, we can capture secular trends, such as improving the energy efficiency of buildings, or the shift to electric transport. The European Green Deal and European recovery plan are directing sizeable investment towards climate initiatives,3 with particular emphasis on refurbishing building stock and digitisation to make the region more competitive. This creates a cushion while global growth is slowing.
The right companies
This is an environment that will test all companies. However, the companies we own are global leaders in their industries. Many do not need a strong European economy to thrive. We invest in companies run by exceptional management teams, with a clearly defined strategy to create value. We favour companies that generate a significant amount of cash and earn good returns on the capital they invest.
This period of high inflation, supply chain disruption and multiple cost pressures has been the ultimate test for management teams. That’s why we pay so much attention to businesses that have pricing power, that have scale in procurement and a strong track record in managing supply chains. The volatility of the last few months has given us the opportunity to add to some of the portfolio’s existing, high conviction stocks.
We don’t have a crystal ball and near-term, the market remains incredibly uncertain. However, a lot of bad news is already reflected in market sentiment. For the long-term investor, volatility creates an opportunity to buy valuable assets at much lower valuations. The regime of ‘lower for longer’ interest rates may be gone, and the world is still changing around us.
This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or financial product or to adopt any investment strategy. The opinions expressed are as of September 2022 and may change as subsequent conditions vary.
1Source: Emerging Portfolio Fund Research, 31 August 2022
3European Commission, 22 September 2022
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