By Raj Shant is head of European equities at Newton Investment Management So far this year, Euro...
By Raj Shant is head of European equities at Newton Investment Management
So far this year, European stock markets have been volatile with a downward bias ' but there are still plenty of attractive themes and stocks in which to invest.
Growth has continued to prove elusive and, although the eurozone inflation rate has remained stubbornly above the ECB's 2% target, the ECB is looking for the recovery to gather steam before reversing last year's rate cuts. We believe interest rates will not rise as much or as quickly as the markets currently expect.
We believe Europe is at a particularly interesting juncture. From the early 1980s to 2000, inflation has been falling steadily. The consequent falls in interest rates helped to buoy bond and equity markets. The market consequence of this was a 20-year trend of stock market polarisation, in which lower-growth firms were de-rated, while high-growth companies became increasingly expensive. In this sense, the technology bubble was no more than the two-year finale to a 20-year symphony.
Now, the process of falling inflation is over. Because policymakers are acutely conscious of the risks of deflation, we believe inflation is likely to stay at present levels. The implication is that the process of polarisation of ratings is at least over. The balance of probabilities is that the valuation differentials reduce. This, in turn, means that some of the biggest stocks and sectors (which dominate the indices by virtue of their extensive re-ratings) look vulnerable, and consequently markets are likely to struggle to show headline returns.
But this does not make us unduly pessimistic. One of the themes running through the Newton European fund is that market breadth will improve. So, just as the late 1990s saw markets rising on the back of very few stocks while many parts of the market were stuck in a stealth bear market, so we believe there will be large parts of the market that can show strong returns.
There is a substantial tier of liquid blue-chips that are not the largest in their benchmarks, or sectors that have been de-rated for many years and now offer good prospects at excellent valuations. A related theme in our portfolios is of EVA Goes Basic.
A lot of basic industries were so severely neglected by the capital markets during the 1990s that effectively they were denied access to capital. This salutary lesson in the cost of capital had a lot of interesting effects. First, instead of building new capacity, these industries began to consolidate, not only to cut costs but also to increase pricing power. Second, they began to focus on lifting returns (stop destroying shareholder value).
Many companies in these types of industries can now boast rising profitability, good cashflows, high yields and often share buy-backs as well.
It could certainly be argued that these stocks and sectors have been performing well already. If your time horizon is 12 months, then it would be easy to think that it is all over. If you look at the longer-term shifts in the tectonic plates, it is clear that we are only some months into a move that could last for years. And that would be particularly interesting for an industry where the majority of investors have grown up believing that sectors like basic industries should only be rented and never owned.
Inflation is likely to stay at the present levels.
Attractive stocks and themes in market.
Firms in basic industries boast rising profitability.
Growth has continued to be elusive.
Some of biggest sectors look vulnerable.
Markets will struggle to show headline returns.
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