European long/short outlook

30 January 2019

2019 may be the proverbial game of two halves… if the market materially corrects, this could present a great opportunity for the second half.

Macro Matrix:

Having peaked in February, our proprietary ‘macro matrix’ indicator deteriorated into ‘impairment risk’ territory by October. The credit markets worsened early in the second quarter due to worries regarding the effect of US Federal Reserve (Fed) tightening and this acted as a lead indicator for macro numbers that contracted more sharply in the second half of 2018. Looking back, an early sign that 2018 was likely to be a ‘risk-off’ year started with the collapse of bitcoin, as well as crises with key emerging market currencies, notably the Turkish lira and Argentinian peso. This, in our view at the time, was not a great surprise as the Fed-driven liquidity squeeze was always likely to be first felt by indebted emerging markets and speculative financial assets. However, this correction then rolled through risk assets, eventually leading to the correction in US equities in December.

Investor Positioning:

Returns & Valuations:

European indices de-rated materially during 2018. The Stoxx Europe 600 price/earnings ratio peaked around 17x in 2015, driven by the European Central Bank announcement regarding its quantitative-easing programme and later at 16x after the 2016-17 rally. By comparison, in 2018 the Stoxx Europe 600 fell to below 12x*. Across Europe’s markets it was a similar story of losses for the year: FTSE -9%; Dax -18%; CAC -11%; and SMI -10%. The main drivers of this were growth companies, many of which de-rated by 20–30%†, and industrials which are now trading at, or below, their 2012-15 range in terms of price/earnings multiples. It is notable, however, that quality defensives continue to trade at all-time-high valuations.

There were very few places to hide and defend in 2018:

• Cyclicals (including steel -25%, building materials -23%, autos -28%, and industrials -15%) were down meaningfully*.
• Eurozone banks (-33%) also had a very tough year*.
• Meanwhile, growth stocks finished the period flat having peaked at +24%*.
• The top-10 mega caps were the only notable place to hide and materially outperformed from March helped by pharma (Novartis +6%, Roche +2%, Sanofi +10%) & food producers (Nestle -2%, Unilever +4%)^†.
• Elsewhere, the MSCI top-10 market caps were up +3%^#.

Performance

In 2018, profitable stockpicking was extremely difficult, particularly on the long side as a vast majority of companies de-rated, often despite there being a lack of negative, company-specific news. Having performed well for much of the year, our long investments were negatively affected more than we had anticipated in the final quarter’s capitulation. In particular, the high-margin, high free cashflow growth stocks were significant laggards. Overall, our stock selection did not have a materially negative affect during the year and maintaining a low net exposure certainly helped limit the downside.

Alpha:

The first nine months of the year were nicely positive for the portfolio, capturing 2.7% in alpha. However, the collapse in growth stocks and cyclicals in the fourth quarter led to negative alpha of 4.1%. Overall, this left us with a small negative alpha for the year.

Beta:

Due to maintaining a low net exposure throughout most of the year, we only captured 21% of the market downside. Our reduction of net exposure during January materially added to the beta performance of the portfolio as did increasing net into September lows.

Balance sheet management

Having initially cut net exposure on the day of the market peak in January, we maintained a lower-than-average net (between 0–45% for the last 11 months), guided by our macro matrix model. We increased our net exposure in September to 44%, which rose to 48% in October as we saw the credit market had improved and stocks we had sold at the peak had fallen significantly. This, however, proved to be a short, false dawn and we therefore reduced net exposure. In hindsight, we should have been more aggressive in cutting higher-beta names and maintaining a very low net throughout the second half of the year.‡

European Long/Short outlook: Scenarios for 2019

As we start 2019, Sino-US trade talks have resumed, Chinese authorities are stimulating the economy through a variety of channels and Fed chair Jerome Powell seems to have provided the assurance needed that Fed policy is not going to choke the US economy via ‘auto pilot’ interest rate rises. Investors should take some comfort from the fact that valuations are much lower now than at the start of last year. The question for investors in 2019 is whether global economic growth will continue to slow down or even halt with corporate earnings materially affected, or will we see 2019 as the culmination of a soft patch for growth and a great opportunity for equity investors.

In the past few years, our outlook has generally been constructive towards European equities. In 2019, we have a more balanced view, as this year is likely to be either very good or very bad depending on how the macro environment develops. The year may be the proverbial game of two halves, with the first six months being highly uncertain and volatile as the market sentiment swings around depending on incremental data. If the market materially corrects, this could present a great opportunity for the second half.

The question for investors in 2019 is whether global economic growth will continue to slow down or even halt with corporate earnings materially affected

Bull Market 40% likelihood

Trading Range 20% likelihood

Markets could rebound in early 2019 given they became so oversold in late 2018. With deteriorating global economic growth in early 2019 the market upside is likely to be limited and equities trade within a 15% range. Under this scenario we would reduce exposure into rallies and buy into weakness until there was clarity on the direction of the economic cycle and central bank policy.

Bear Market 30% likelihood

The Fed will be seen to have over tightened, global growth suffers more than expected, deflationary pressures re-appear. Risk assets including European equities perform badly. Eventually the Fed cuts interest rates and stops reducing its balance sheet. Should this happen, we would maintain a low, or short, net exposure until the credit and macro indicators stabilise. Positive returns will only be generated from short positions where the focus would be companies with high operational and financial leverage. As the huge majority of share prices fall and de-rate, the long positions will aim to outperform the index.

Collapse 10% likelihood

As we have mentioned in previous outlooks, the bear market outlined above could become a full-blown crisis with a breakdown in global trade, debt defaults and/or the break-up of the European Union. Opportunities to short will be high, with many stocks falling dramatically and many requiring refinancing. We would remain net short until all central banks begin returning to materially expansionary policies.

Past performance is not a guide to future returns. The return may increase or decrease as a result of currency fluctuations.
The information provided should not be considered a recommendation to purchase or sell any particular security. It should not be assumed that any of the security transactions discussed here were, or will prove to be, profitable.
*Source: Bloomberg as at 31 December 2018. †Source: FactSet as at 31 December 2018. #Source: Martin Currie and FactSet as at 31 December 2018.
‡Source: Martin Currie over twelve months to 31 December 2018. Strategy figures in Euro from representative account using official NAVS calculated by the administrator and net of all fees and expenses. This data is presented net of investment advisory fees, broker commissions, and all other expenses borne by investors. The figures provided includes the reinvestment of dividends. The annual fee rate used is 1.50% with a 20% performance fee. The strategy is not constrained by a benchmark but is shown versus the MSCI Europe (LC) for illustration purposes only.