Aviva's John Botham on the opportunities for European equities on the longer-term horizon
In recent weeks, the strong equity market rally that began in March 2009 has stuttered as the prospects for a sustained economic recovery appear to hang in the balance.
A stronger-than-expected Q1 earnings season, a continued superior growth outlook across many Asian countries and improving economic conditions in the US helped buoy optimism that the global economic recovery was on course, although more recently this has been tempered by the risks arising from the sovereign debt crisis in Europe and subsequent fiscal retrenchment.
In contrast to other parts of the world, the economic recovery in many Continental European countries has been slow. Of particular concern has been the excessive levels of government debt and hence the credit worthiness of certain countries in southern Europe – most notably Greece, Spain and Portugal. Against this backdrop, the euro has fallen in value relative to the dollar as investors remained concerned about the inflationary impact of any bailout by the central bank, and indeed the future of the euro currency as a whole.
Export sensitivity
Companies and sectors sensitive to the global economic recovery and the export markets (most notably capital goods, automotive and luxury goods) by and large have performed well since the beginning of the year. By contrast, so-called mature defensives, exposed to their domestic European economies such as utilities and telecommunication services have also failed to keep up with the strong cyclical-led rally. Investors remain concerned by poor profit growth momentum and the risks of more ‘windfall’ taxes.
Many financial stocks have also suffered owing to the likely introduction of tighter regulations, ongoing balance-sheet de-leveraging and the risk of further asset write-downs, particularly those banks or asset managers most exposed to the sovereign debt issues in those troubled countries. I believe it is too early to increase exposure to the sector although it is becoming increasingly interesting looking at the recovery potential of banks and their discount valuations versus history.
Geographically, Germany, Benelux and Scandinavia have outperformed the southern European equity markets.
Outlook
So what is the outlook for equity markets going forward? In our view, cautious optimism is the name of the game. Given the strength of the rebound in equity markets, it is unlikely the aggressive growth momentum seen in equity markets in 2009 and over the first quarter of 2010 will continue, especially in light of the potential headwinds, such as excessive government and consumer debt, the inevitable tightening of fiscal policy and over-optimistic expectations for corporate profitability in some areas of the market. We are also likely to see continued high levels of volatility as investors digest the impact of ongoing newsflow around the economic recovery.
Nonetheless, over the next two to three years we expect investors will earn an attractive positive return from holding equities, outpacing risk-free investments such as money-market securities and government bonds on an absolute return basis. The current lax conditions in monetary policy are likely to continue and will encourage the switch from cash to equities and bonds. Equities appear to us relatively cheap and unloved compared to history.
Caution
However, investors should remain cautious on particular areas of the market, especially companies where valuations already discount benign economic conditions, such as many cyclical sectors where investor enthusiasm is getting ahead of reality. We are undoubtedly in an environment of increased regulation and widespread public sector spending cuts as governments look to address their fiscal deficits, therefore we are pessimistic on companies exposed to these risks.
In general, we have a preference for higher-quality, lower economically sensitive stocks and selected cyclical stocks where expectations and valuations are not already discounting a strong economic recovery. In my view, an example of an undervalued cyclical stock is Bilfinger Berger.
This has traditionally been a German multi-service construction company, but their business model is increasingly shifting towards being an industrials servicing company. I believe the current valuation is undervaluing an earnings stream, which is likely to prove more resilient and less cyclical going forward. Another example is Bwin, a leading online gaming company that is well positioned to benefit from the increasing consumer demand for online gambling, especially as many governments across the globe begin to regulate the industry.
Healthy earnings
Healthcare is an attractive more predictable earnings growth sector. The valuations of many pharmaceuticals are trading at all-time relative lows versus the market and do not reflect the attractive defensive earnings growth and cashflow returns. The sector is currently discounting excessive bad news (expiring patents and healthcare reform), but none of the potential positives, such as emerging market growth and cost efficiencies.
We are cautiously optimistic on the prospects for equities. While risks to the economic recovery remain, at a stock-specific level, we can still find plenty of companies across a broad range of sectors offering attractive long-term capital appreciation and cashflow return potential.
John Botham is European equity manager at Aviva Investors
