European equity hedge fund managers have had a tough time so far this year. The EuroHedge European Long Short Hedge Fund Index is up just 2.1% through August and many pure LSE managers have reported negative YTD returns.
The underlying rotations within European equity markets that have taken place this year have been counter-intuitive at times and difficult to navigate. Defensives have outperformed cyclicals. Large caps have outperformed small and midcaps. Financials, which are poised to be the biggest direct beneficiaries of the European Central Bank’s (ECB) easing policies, have underperformed utilities by almost 13.8% YTD (based on MSCI Europe Financials and Utilities through August 2014). These rotations have made it a difficult environment to navigate for most active equity managers, especially managers with a bias towards “recovery” stocks (usually cyclicals and financials). Following 12 months of strong inflows into European equity funds, according to EPFR Global flows, August 2014 data showed a sharp investor retreat, especially by US investors.1 European-focused mutual funds and ETFs experienced the largest weekly outflow since before ECB President Draghi’s “Whatever It Takes” speech in August 2012.
The reasons for these rotations and subsequent performance differentials are multi-fold, and include concerns regarding the impact on Europe’s economies (especially on Germany) of the Russia/Ukraine conflict and sanctions imposed by the West on Russia and vice versa, a disappointing Q1 earnings season and nervousness around continued earnings downgrades, and slowing momentum in the EA economy. Other factors are dilutive capital raises in the banking sector as banks have been in balance sheet repair mode ahead of the release of the ECB AQR/stress test results, heightened deflation fears as prices have continued to drop, and questions whether the ECB and European politicians are far behind the curve in tackling Europe’s high debt, poor growth, low inflation problem.
These factors contributed to struggling equity markets and flows out of cyclicals and small caps in particular and into safe havens, large caps, and defensives. The latter rotation wasn’t specific to Europe; in fact, the same phenomenon has occurred in the US (see graph on next page). Note that the underperformance of cyclicals versus defensives correlates tightly with the move in interest rates. As many hedge fund managers came into 2014 positioned in cyclical names where value was perceived to be greatest, they got caught off guard by the unexpected sharp decline in interest rates which kept the search for yield ongoing and the attractiveness of cyclicals low. The preference of defensives over cyclicals in European equity markets clearly signaled risk aversion and uncertainty about the direction of the economy and the tug of war between inflation and deflation expectations. However, credit markets have largely been void of warning signs. Liquidity conditions in the underlying economy have significantly improved (as illustrated by the sharp decline in spreads of sovereigns, HY, and other types of credit, but also macro indicators such as the improvement in M3 money growth and stabilization of bank lending), while liquidity conditions in cyclicals and small/midcap stocks have continued to deteriorate. For how long can this divergence continue and will European stocks continue to struggle?
Despite the challenges faced so far this year, we believe the sell-off has created some compelling buying opportunities. Moreover, we see significant tailwinds in H2, which include:
- Signs of a pick-up in global growth, driven by the US. US data has mostly surprised to the upside in recent months. Although US growth is expected to be much more robust than EA growth, most analysts expect a pick-up in EA growth as well (~0.2-0.3% QoQ in Q3 and Q4).
- ECB monetary policy programs including Targeted Longer-Term Refinancing Operations (TLTROs) which should continue to reduce funding costs for banks and small and medium-sized enterprises (SMEs); the implementation of “QE-lite”2 and increased signs that “full-blown” QE (i.e., including sovereign bond purchases) is on the table should help to stimulate growth and inflation expectations. Draghi has all but promised that he intends to grow the ECB balance sheet by EUR ~1trillion; failure to do so would jeopardize the ECB’s credibility.
- Divergent monetary policy contributing to a weakening Euro, which should help to boost exports, reduce deflationary fears, and support corporate earnings. In fact, Q2 earnings season was in line with expectations (unlike prior seasons), and earnings revisions are now starting to turn positive after multiple quarters of negative revisions.
- The AQR/bank stress test results due for release in mid-October; this should serve to finally remove the blanket of uncertainty regarding the state of EU bank balance sheets. Going forward, the ECB will function as the bank supervisor and there will be increased harmonization of bank balance sheets across Europe.
These tailwinds seem poised to support some specific opportunities in equities that we are currently focused on:
- Cheap, well-capitalized financials: Given the aforementioned pressure on financials, the baby appears to have been thrown out with the bathwater. This has created significant dispersion in valuations of European banks, with many Italian and Greek banks trading at significant discounts to book value. For example, several Italian banks are trading at 0.5-0.7x TBV while other financials are at 1-1.2x. Yet Italian banks should be among the biggest beneficiaries of the TLTRO and other easing measures as they have large SME portfolios and will benefit from reduced funding costs, most are well capitalized (the AQR/stress test results should act as a catalyst to highlight this) and have sustainable return on equity (ROE). In the medium term, industry consolidation is also highly likely (Italy has one of the most fragmented banking sectors in the world), which should help to improve ROE. Conversely, there are also attractive short opportunities in EA financials where banks are still undercapitalized yet trading at expensive valuations.
- Domestic recovery names: These are companies in sectors that are most geared to a recovery in domestic demand, such as in autos, industrials, media, real estate etc. Many of these companies have experienced steep multiple compression in the underlying rotations of recent months, but should benefit the most from the recovery in demand as supply in many industries has been reduced during the crisis years. Many of these companies are also in a good position for M&A given conservative spending over many years and high cash balances.3 Real estate in particular is still one of the true deep value opportunities in equities, and in many cases the NAVs of distressed homebuilders, REITS, and closed end funds are trading at levels much below the value of the assets. As some countries (Spain, Ireland) are doing much better from a macro fundamental perspective than others (Italy, France), it is crucial to marry bottom-up stock picking with an understanding of these broader macro trends and their potential impact.
- Corporate restructurings: A lack of growth in the region has increased the need to drive earnings growth through business restructurings and industry consolidation. Industries such as telecom, real estate and healthcare are in the midst of consolidation, and opportunities exist to pre-position or benefit from names for which deals have been announced but synergies haven’t been priced in. In terms of corporate restructurings, it’s not especially industry specific, although media companies and many core country banks are considered attractive as they are far advanced in their restructuring initiatives.
The European economy is surrounded by uncertainty, the political dynamics are complex, and policy is in flux but increasingly supportive. However, even with a “muddle through” economic scenario, at current valuations, we believe that the opportunities discussed above are compelling.
Source: Datastream, Goldman Sachs Investment Research
1 The Flow Show, Bank of America Merrill Lynch, 14 August 2014.
2 “QE-lite” refers to the ECB’s recently announced ABS and covered bond purchases program.
3 Goldman Sachs estimates that European corporates will generate EUR2.1tr of Free Cash Flow over the next five years.
4 Cyclicals: Media, gen retailers, travel, leisure goods, chemicals, basic resources, construction & materials, industrial goods & services, autos & parts
Defensives: Food & beverages, tobacco, healthcare, food & drug retail, utilities.
Melanie Rijkenberg, CFA, CQF is an Associate Director working in Portfolio Management. She is currently focused on European capital markets and manager research and is responsible for certain institutional client relationships. She joined PAAMCO’s Irvine office in 2010 and moved to Europe to join the firm’s London office in the Spring of 2012. Prior to joining PAAMCO, Melanie was an Analyst in the Pension Advisory Group at Integrated Finance Limited, a New York based boutique investment bank, where she focused on the development and sales of a proprietary pension product. From 2001 to 2003 Melanie competed on the US National Field Hockey Team. Melanie received her MBA from Columbia Business School, her Master of Science in Political Science from the University of Amsterdam and her BA in Psychology from Princeton University.
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