Europe appears to be firmly in the grip of a ‘third wave’. Rising case numbers and a slow vaccine rollout have forced politicians to implement new lockdowns. Even where lockdowns haven’t been imposed, citizens have started to take things into their own hands and stay at home. This puts the region’s nascent economic recovery in peril.
Could this change the mood in equity markets?
The Eurozone economy had been recovering. The most recent PMI data showed manufacturing output growth accelerating to its highest level since records began in 1997. The upturn has been led by a surge in Germany’s factory production, though France has also seen the fastest production growth since January 2018.
However, there were clear vulnerability. Services have continued to lag, for example. PMI data showed it remained under the all-important 50 mark that signals expansion. The decline had slowed but any improvement continued to be constrained by covid restrictions. This is the area that looks most vulnerable to further lockdowns as case numbers rise and comes amid a more worrying trend for higher input prices: March also saw firms’ costs rise at the fastest rate for a decade.
More resilient than expected
In spite of this worrying backdrop, over the past month, Eurozone markets have notably outpaced their peers. The Eurostoxx 50 is up 5.2%, the Dax is up 7.0% and the CAC 40 is up 4.7%. This compares to a rise of just 2.1% in the S&P 500 and 2.0% in the FTSE All Share. The region has benefited from the rally in ‘value’ areas since November, where it has higher weights, while growth areas have been left behind.
Could this change if recovery comes through more slowly than many expected?
Colin Moore, global chief investment officer at Threadneedle Investments, points out that both economies and stock markets have generally been more resilient than expected in the face of repeated lockdowns. Equally, he takes issue with the idea that the vaccine rollout has been slower than expected: “We always held the view that there could be difficulties, particularly with the Modern and Pfizer vaccines given the refrigeration issues. If anything, things are happening faster than we initially expected.”
He also points out that efficacy of the vaccine has been better than expected.
He takes the same view on economic recovery, suggesting it is still occurring faster than the group had initially expected: “We expect the economy to keep broadening in terms of the amount of activity and the companies exposed to that broadening activity will do better.” Investors need to take into account the stimulus package filtering its way into the Eurozone economy, he adds. There will be bottlenecks, but recovery should come through this year.
A greater concern for the group is that the pick-up in inflation may be transient. Investors may now be extrapolating the inflationary trend too far in the future and Threadneedle believes that economies will return to a low growth, low interest rate trend. This will create headwinds for economically sensitive companies in the longer term. There will be a ‘sugar rush’ of recovery and then decelerating growth in 2021, which will push inflation and interest rate expectations lower.
This doesn’t bode well for those companies that don’t have a lot going for them beyond their cyclicality. Gareth Rudd, fund manager on the Chelverton European Select fund, has avoided the recent enthusiasm for cyclical and deep value areas: “On the face of it, many of these companies might look cheap, but they face structural challenges and their margins are under long-term pressure. Where they’ve made capital expenditure their balance sheets have often taken the strain. These companies have been swept along in the general ‘value’ rally.”
He cites companies such as Orange, EDF Energy and BMW. They may appear good value, but investors need to look at what they hold once the initial recovery rally is over and many don’t have long-term growth prospects. Equally, he believes, if these companies’ share prices are solely supported by economic recovery, these are the areas that look most vulnerable to any renewed weakness from a third wave of covid-19.
The problem is that, in the meantime, the growth companies that had been popular during the uncertainty of the Covid crisis don’t look particularly appealing either. Rudd cites companies such as LVMH, L’Oreal, SAP or Addidas. These companies still look too expensive. The have strong cash flow, but it comes at a high price. Their approach balances valuation and cash flow and these companies score poorly.
A more nuanced approach
This seems to suggest the opposite of Goldilocks market, where sectors are either too hot or too cold. ‘Growth’ is too expensive in a potentially inflationary environment, while many ‘value’ areas don’t have enough long-term growth to sustain them if the Eurozone economy is hit by a third wave.
Europe’s saving grace is the breadth and depth of the market. Rudd can find plenty of companies that offer a ‘middle way’, particularly among small caps, which have been hit by the Mifid II effect – whereby a lack of coverage has led to widespread mispricing.
The rally in some ‘deep value’ companies may be vulnerable should Eurozone economies be hurt by a third wave. However, they may have been vulnerable anyway, given that the bounce in inflation was likely to be transitory. The current enthusiasm for cyclical areas is likely to ebb, not to be replaced by a renewed enthusiasm for still-expensive growth companies, but possibly by a more nuanced appreciation of all that European markets have to offer.