What Happened in May
Eurozone equities experienced a strong start to May, boosted by expectations that Emmanuel Macron would secure the French presidency. However, despite positive news on the eurozone economy, shares suffered a sell-off in mid May as they were unsettled by rising political turmoil in the US, ending the month with modest gains. Almost all sectors advanced, with the strongest returns recorded by the utilities, telecoms and real estate sectors, all of which are seen as bond proxies. Only consumer discretionary and materials stocks retreated.
Economic news indicated that momentum in eurozone growth was continuing to pick up. The composite eurozone purchasing managers’ index (PMI) remained at a six-year high and the German Ifo business climate index rose to a record high in May. Inflationary pressures also eased with headline inflation falling to 1.4% in May, down from 1.9% in April, while core inflation slid to 0.9% compared to 1.2% in April. With inflation remaining subdued, the European Central Bank (ECB) opted to keep both rates and its bond-buying programme unchanged.
ECB president Mario Draghi commented that the eurozone still required “an extraordinary amount of monetary support” in spite of the growing economic recovery. UK equities outperformed those in the eurozone over May (in GBP terms), as sterling’s weakness helped boost the value of UK-listed companies’ overseas earnings. UK Q1 gross domestic product (GDP) growth was revised down to 0.2%, from a previous estimate of 0.3%, although surveys suggested economic activity had picked up in April. UK inflation rose to 2.7% in April, its highest level since September 2013.
The Fund outperformed its market segment in May in the continued rally of Euroland equities. Stock selection contributed positively to performance, however, there was a negative impact from the sector allocation versus the benchmark, particularly due to the underweights of utilities, telecom services and real estate.
Outlook and Strategy
We take an increasingly constructive view on the European macro environment, as an improvement in cyclical data, and a much awaited earnings recovery, overshadow the gradually subsiding political risk. The region remains under owned internationally, with investors having shied away from the perceived heightened political risk, favouring the outperforming yet richly valued US market. Even within Europe, equities are unloved and under-owned. Domestic European investors are overweight fixed income at a time when its 30-year bull market appears to be challenged. Recent flow data though suggests this underweight positioning appears to be closing with Europe beginning to see inflows both at home and internationally.
Europe’s economic prospects continue to improve, with the latest PMI reading for the eurozone coming in at 56.7, a 71-month high. This should not be mistaken purely as Trump induced optimism, but has been supported by continued loose monetary conditions, Chinese and moderate European fiscal stimulus, and a slowdown in private sector deleveraging. This economic activity has been reflected in a strongly improving European earnings picture. Q4 2016 earnings delivered a 20% net beat, the best for 6 years. Crucially this occurred at a time when earnings continue to be upgraded, with the current Earnings Revision Ratio standing at 1.07 (again a 6 year high). The improvement in earnings is broad based, and aided by top line growth, not just cost cutting. Importantly many of the factors that have held back European earnings in previous years, are now acting as welcome tailwinds. 1) Deflationary pressures have subsided, and a pickup in inflation should benefit corporates nominal top line growth, particularly with pricing power, able to pass on input cost pressures. This is particularly relevant at a time when margins are depressed, presenting the opportunity for operating leverage. 2) Commodity prices have stabilised (circa 20% of the European market is exposed to the commodities). 3) Emerging markets exposure is no longer acting as a drag.
With the re-election of Rutte in the Netherlands, and the Macron victory in France, political risk also appears to be declining. Politics however remains evident in European valuations, with the region significantly under-valued relative to other developed markets, notably the US, where on a sector adjusted P/B or CAPE basis the valuation discount is >30%. At a time when Trump’s much speculated fiscal stimulative policies are being questioned after the failure of the recent healthcare reform bill, and the unknown impact of protectionist policies, the two economies could well be heading in divergent directions.
We continue to focus on high quality businesses, with sustainable long term competitive advantages, which provide a level of visibility that one currently struggles to find in any political policy. In a corporate world, increasingly challenged by disruption and innovation, these companies possess the necessary attributes to compound their high returns over the long term.