By Ken Hsia, Portfolio Manager of the Investec European Equity Fund
Europe has often been mentioned in conjunction with the word crisis lately. Most recently it was the general election in the UK, where Theresa May failed to achieve the majority she wanted in order to give her the political backing for her negotiations on Britain's EU exit. It is worth noting the Brexit referendum itself had caused the MSCI Europe to fall over, in the short term. Other political uncertainties like the gains made by populist parties, in France, the Netherlands and Germany, have also undermined investor confidence in Europe. On top of all that, financial crises like the Greek sovereign debt crisis – ongoing since 2012 – or the global financial crisis (2007 to 2009) have all been a source of insecurity and volatility.
From an investor standpoint, Europe is in constant competition with other major equity markets and changes to its political climate can make investors move their capital around. The U.S. was generally seen as a haven of stability, the promises made by Donald Trump during his election campaign, as well as shortly after his election, made U.S. capital markets more attractive. However, doubts have come to the fore as investors questions the 45th US-president’s implementation road map. Confidence in Europe is returning, partly as election results have allayed some fears of populism but, more importantly, as economic recovery is taking hold resulting in strong corporate earnings growth - it is the latter which we believe drives sustainable value.
Whilst headlines can focus on the negatives, there is progress being made. Stability in the banking industry has taken a leap forward since the end of 2016. The Italian banking industry has successfully raised new capital through the €13bn equity raise for Unicredit and the €20bn bank bailout fund established. Though the future of some of the banks remain in doubt, systemic risk has been averted. The same happened in Spain where weak banks have been swallowed by stronger competitors. Santander, number 3 in its home country, took over Banco Popolar, the local number 6 – and became the Spanish champion in doing so. These trends do not only make the European banking sector more stable, they also sprout new investment opportunities.
We believe the exposure to European equities should not exclude British stocks and shares after the Brexit. Equity benchmarks will continue to include the UK as they do Switzerland and Norway. The UK stock market is the home to many globally diverse companies such that 75% of revenues for the FTSE100 index comes from outside the UK. Though Brexit forms some challenges ahead we believe the main issues lie in the rules and regulations rather than the tariff system as we had initially believed. As a Customs Union, the EU applies typically 1-3% tariffs across a range of industries, typically commoditised. With the devaluation of Sterling and spare capacity, companies have reasonable flexibility to deal with the tariffs. Doubtlessly, companies may need to adapt. Some will have to open a subsidiary in the EU and for the UK asset management industry some will have to launch EU-domiciled funds. However, we do not believe Brexit poses systemic risk to the region, especially as there is reasonable time to prepare. We also note the recent UK elections has not given the government the mandate to a “hard Brexit”.
Today’s corporate landscape is much more resilient, 80% of corporates fall within the service sector and are therefore more specialist and less capital-intensive. They also have a high global orientation. Examples here are Prudential and HSBC. The British life insurance provider Prudential, for instance, is heavily involved in Asia and currently generates 95% of its profits in new business outside of the UK. HSBC, a major bank that relocated its headquarters from Hong Kong to London as recently as 1992, has an equally international orientation.
We believe a stock market always recovers from a crisis: they rise over the long term in developed markets. This is due to companies allocating capital to achieve sustainable returns above the cost of capital. However we note that public debt levels remain at high levels compared to history. These attributes underline the need for well diversified portfolios and we believe that European Equities should be core to such portfolios.