UBS head of concentrated alpha equity Maximilian Anderl
At the start of the year, investor confidence in European equities was returning. Growth rates in the eurozone were at a 10-year high. But the election of a populist Eurosceptic government in Italy in the Spring – coupled with a fall in first quarter GDP growth – has punctured that optimism.
“It’s going to be hard for growth to materially bounce back in Europe until after the Italian budget in the autumn,” said Erin Browne, head of asset allocation at UBS Asset Management, speaking at the group’s mid-year market outlook.
Italy’s coalition government – led by the anti-establishment parties Five Star and the League – have vowed to slash taxes, raise welfare spending and challenge EU fiscal rules. The new government’s first budget is expected in October.
“Ahead of the Italian budget, we expect dampened business confidence and increased risk,” Browne said. “But in the fourth quarter you could see a bounce back as the risk event passes and business confidence begins to build back up again.”
Banks and consumer staples
Despite Italian concerns, UBS remains slightly overweight on Europe overall. “We are very specific in terms of the spots that we are picking in terms of the sectors and the country exposure,” Browne said.
UBS head of concentrated alpha equity Maximilian Anderl said “cherry picking” European banks in the present environment could present attractive opportunities. Anderl is the lead manager on UBS’s Luxembourg-domiciled €498m European Opportunity fund.
European Opportunity fund vs benchmark (three-year performance)
Source: FE Analytics
“European banks have got beaten down pretty substantially but if we start to see rate hikes in Europe in 2019, then they could do well,” he said, adding that Nordic banks held particular appeal.
“We like the Nordic banks, you are picking up 7-8% dividend yield outright or including share buybacks, so you do not have to do much just hold onto the stock,” Anderl said. “Many Nordic banks have underperformed eurozone area banks so from a risk-reward perspective they are quite good.”
The European Opportunity fund’s holdings include Nordic financial company Sampo (2.5%).
The fund is also invested in blue-chip European consumer staples, such as Diageo (3.3%) and Heineken (2.4%). Consumer stocks have experienced something of a selloff over the last year creating a buy opportunity, Anderl said. “There is an opportunity to pick up some interesting names.”
The European Opportunity fund’s largest holding is in Royal Dutch Shell (5.9%).
“European oil and gas companies are benefiting from the rebound in oil prices, the stronger dollar and refining margins on top of that,” Anderl said, adding that integrated oil companies in Europe now have better balance sheets and the cash flow to pay out 6-7% dividends.
“Royal Dutch Shell has capacity to do share buyback. I think you will see a lot of more cash flow coming investors’ way,” he said.
The fund’s holdings also include LVMH Moët Hennessy Louis Vuitton (4.2%); Reckitt Benckiser (3.8%); Astrazenica (2.8%) and Safran (2.8%).
The technology deficit
Browne said one of the structural challenges European equities have in attracting international investment was the relative weakness of its tech sector compared to other parts of the world. Tech stocks make up just 5.4% weight of the S&P Europe 350 – compared to 25% of the S&P 500.
“The S&P Europe 350 is a value-oriented index dominated by the financial services industry. But a lot of global equities growth is in the tech sector,” she said.
“The US IT sector is a huge growth sector,” Anderl added. “It’s phenomenal how these companies can grow despite their size and still be very attractive in value, particularly in light of their recent regulatory issues.”
The Cambridge Analytica data scandal in March led to a sell-off of FAANG stocks (Facebook, Apple, Amazon, Netflix and Alphabet’s Google) but the losses have since been regained. “Consumers could have cancelled their Facebook accounts but that has not really happened. Most people don’t care,” Anderl said.
In July, Google was fined €4.34bn by European Commission for using its Android mobile operating system to illegally cement its dominant position in search.
“The FAANG companies cash flow generation remains tremendous and when their shares stand still for a while they become extremely attractive,” Anderl added.
Browne added: “The challenge for Europe is how to outperform when less than 5.4% of the market is the tech sector compared to 25% in the US.
“Value typically outperforms growth early in the economic cycle when you are coming out of a recession or when there is a really big spike in inflation. However, we are not seeing a material pickup in global inflation and we are not in a recession. During these periods, growth strategies tend to work and that at the moment does not favour Europe.”