2017 saw a combination of a worldwide cyclical upswing of activity; favourable inflation surprises (producing a continuous appreciation of risk assets); and unprecedented low volatility. European equities have reflected earnings growth, rather than multiple expansion. Markets have rewarded those where profits have surprised positively, while penalising those which have disappointed. Unlike 2016, when political turmoil obscured Europe’s nascent recovery, its been clear in 2017 that continued strong economic growth has helped drive earnings upwards. While expectations of UK economic expansion remained relatively unchanged at 1.5%, estimates for European growth for the last year rose to 2.3% in the European Commission’s Autumn Economic Forecast (revised up from 1.6%).*
Unlike 2016, value has struggled, with oil producers in particular underperforming. Outperformers have included growth stocks and cyclicals.†† While there have been periods of rotation between themes, these have not been material.
Did your strategy perform as you would have expected in 2017?
Being a directional long/short strategy, our aim is to add stock-selection alpha and market-direction beta. In 2017, although the fund was initially held back by a rotation to defensives, we held our conviction that growth would improve materially greater than was expected by consensus forecasts. As this dynamic of improving growth unfolded, we added material alpha, primarily due to the long portfolio – where strong performance came from a wide variety of industries. These included a low-cost airline, a Turkish retailer, a Hungarian bank, a global building-materials firm and a dental-implants developer, all of which contributed materially to performance. There was also alpha from the short book, helped by media, construction and jewellery names.# With our constructive view on markets, we maintained a high net exposure, which meant we captured a large proportion of the rising market. Style wise, having increased our exposure to value stocks in Autumn 2016, we took profits and increased our exposure to quality stocks, therefore ensuring the portfolio covers a good breadth of investment themes.
What do you think will be the key drivers for your markets in 2018?
Forecasts for European economic growth have continued to rise – the European Commission’s most recent forecast for both the euro area and European Union in 2018 were revised up to 2.1%. Thus far, we feel the market response to better European growth has been muted, partly due to the strength of the euro. However, we are optimistic that corporate results could surprise on the upside in the first half of 2018.
How are earnings revisions and valuations looking relative to historic averages and other markets?
Although earnings trends are encouraging, the breadth of positive earnings revisions is still held back by a number of factors: euro strength, the fact that price increases have generally only covered a rise in the cost of materials and that low bond yields are not helping bank earnings. Valuations do not look stretched – many valuation metrics are in-line with longer-term averages. Investors are not euphoric, in fact the large majority remain cautious.
What are the biggest risks to your markets in 2018?
With rising US interest rates and the end of quantitative easing there continues to be a risk that bond yields normalise too quickly. Inflation has been subdued, but if this were to change, it could trigger a correction in the bond market. As equities are benefiting from the high valuation of bonds, any de-rating is likely to affect equities for a short period of time. Likewise, if the oil price was to fall back towards the levels seen in early 2016, this would be deflationary and dampen economic growth.
We believe equities prefer a ‘Goldilocks scenario’ of reasonable levels of inflation, interest rates and growth. However, there may be a period where equity markets weaken, as they adjust to this scenario – reflecting worries about higher rates and tightening liquidity.
During the later stages of 2017, investors have become increasingly cautious, reducing investments in both European equities and bonds. There has been even more discussion regarding the peak of equity markets. However, with improving global growth we expect the backdrop to favour equities during 2018 – although markets are likely to be more volatile than last year.
What sustainability themes do you see yourself engaging with companies on most in 2018?
As ever, we consider governance is key to a company’s sustainability and we will continue to focus on that in our engagement. In terms of wider sustainability themes, over the long term, we believe the move to electric vehicles, will be one of the most significant in the next few years, given the drive to lower greenhouse gases, as well as diesel particulates. This will be an important focus in our research and company engagement. In particular, we expect to see some very big step changes in the battery technology market in the coming years. Development of long distance, super-chargeable batteries is critical to the success of the market.
We also see a new supply line coming through in the renewable energy sector. Led by environmental needs, social pressures and changes to legislation, wind and solar energy are disrupting a century-old model of providing electricity. As an example, under the Renewable Energy Directive, the European Union is required to fulfil at least 20% of its total energy needs with renewable energy by 2020. The development required to support this is the need for a storage solution, if this need is fulfilled, we will, in effect, be able to take homes off the power grid.
What is driving balance-sheet positioning at the moment?
Given the positive backdrop for the global economy and with Europe growing strongly, our positioning remains constructive as it was last year. Our exposures are spread across different themes and styles from European cyclical growth, global consumer brands, and some financials. Short positions focus on structurally problematic companies where revenues and profitability are currently under pressure, for instance in the media industry.
In late 2016, we raised both the net and gross exposures of the portfolio, seeing that growing corporate confidence was not being reflected in either economic forecasts or earnings expectations. We remain confident that economic and earnings growth will again exceed expectations in 2018 and have kept the balance sheet on a more optimistic footing. The early cycle gains driven by market revaluation are behind us, and, as in 2017, earnings will be the key driver of stock performance, both long and short.
European strategy outlook: Scenarios for 2018
With a backdrop of global synchronised growth and some inflation, we see the overall investment landscape currently as the ‘Goldilocks scenario’ mentioned earlier. This should be positive for corporates – notably those closer to the economic cycle – as they should see decent growth in volumes coupled with the ability to raise prices, while operational gearing could mean some margin expansion. We expect European banks to continue to be correlated to bund yields and spreads. Much of the market risk depends on inflationary or deflationary pressures from here.
Bull Market 50% likelihood
With the European economic cycle lengthening and improving, we are optimistic equity markets will respond positively and can deliver similar returns as seen in 2017. The opportunity will be spread throughout the market and a general revaluation upwards is likely. Mid-cap growth stocks should continue to perform well, as they provide authentic structural growth. Despite the positive backdrop, weaker business models will continue to struggle and give us opportunities to create short alpha. We would maintain a high net exposure and see any market weakness as an opportunity to add to gross and net.
Trading Range 30% likelihood
After a strong start to the year, European markets struggled to make meaningful gains in 2017. This could continue throughout 2018, within a 10% range if uncertainties rise. Under this scenario, we would reduce exposure into rallies and buy weakness until there was clarity on the direction of the economic cycle and inflation.
Bear Market 15% likelihood
As we have commented for the last few years, the likely cause of a bear market would be a global slowdown affecting all economies. In this scenario, deflationary pressures would reappear, credit conditions would worsen, there would be a flight to quality and concerns about highly indebted nations being forced out of the euro would accelerate. Politically, this would lead to a further wave of populism and greater protectionism. We would position the strategy with a lower, or even negative, net exposure; we would focus shorts on those companies with weak balance sheets and short-cycle businesses, in particular banks and industrials.
Collapse 5% 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.
*Source: European Commission. †Source: Bloomberg as at 29 December 2017.
**Source: Bloomberg 12 months to 29 December 2017. ††Source: Martin Currie and Lipper 12 months to 31 December 2017.
#Source: Martin Currie year to 30 November 2017.