Navigating a more unpredictable European outlook as economies normalise

QThere is a lot weighing on European sentiment – regional elections, the pandemic, the ECB and post-Brexit bickering. What is the effect on regional markets?

With all those headlines, we might have expected more volatility from regional stocks. Yet markets are at their all-time highs and 60% above the March 2020 pandemic lows. While Europe has benefitted from exceptional levels of stimulus, in GDP terms many of its economies have not yet normalised and in some cases are only now approaching 2019 levels of output.

QWhat are you expecting for 2022?

Almost certainly, there will be more unpredictability. With markets at new peaks, and trading on 16x price-earnings multiples versus a long-term average of 14x, we are now meeting some headwinds. Supply chains are an obvious one, but these are being fixed, and in retrospect, I don’t think they will be regarded as significant. More important are rising energy prices, leading to higher inflation. This could be an issue as Europe is a net importer of oil, gas and other energy sources.

QSo, energy and inflation are interlinked risks. How does that feed into sector opportunities?

While rising energy prices offer a tailwind for the producers, that reverses for companies where energy is a large cost component - we are not exposed to airlines, for example. Elsewhere, we are overweight banks as they are set to benefit from loan growth currently at higher levels than at any time over the past decade, while a normalising interest rate environment means lending margins should also expand. Valuations here do not yet reflect the more attractive outlook, especially on a 10-year view.

QAnd elsewhere, how are you positioned?

We are pro-cyclical, which means that we try and maintain a balanced portfolio, keeping our beta close to one. Apart from banks, we are also overweight consumer discretionary, where the pandemic induced closing and reopening of economies has resulted in very mixed earnings momentum and led to a derating for some e-commerce retailers. We believe this is a structurally growing sector.

Against the backdrop of rising inflation, we are also exposed to sectors with pricing power, which enhances the quality of returns over a cycle. This includes paper and packaging, and even steel, where China’s policy of reducing exports reverses its trend of flooding the rest of the world with cheap steel, which should have positive pricing dynamics.

Our underweights include lower beta sectors, which had benefitted from the low interest rate environment, but will now face increasingly negative operating dynamics. This includes healthcare and consumer staples, where raw material price inflation is pressuring margins.