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Will the ECB remove headwinds for European funds?

Euro symbol in front of European Central Bank, Frankfurt, Germany

Last Word Research shows that investor sentiment on European equities was down by 17% in Q4 2018, experiencing the biggest fall among the 26 asset classes monitored by the team. Wary due to political and economic uncertainties, many investors currently prefer to look globally when it comes to equities.

But despite such low sentiment, is there a case for sticking with European equities?

One for the contrarians

John Husselbee, head of multi-asset at Liontrust, advocates being a patient, long-term investor, and says it is important to not try to be clever and time the market.

“Our approach is to tilt our portfolios to what we see as the inexpensive areas of the world, and Europe very much fits into this category,” he says. “This has been supported by negative investor sentiment and poor economic fundamentals in terms of unemployment, inflation and GDP growth.

“Europe, which relies heavily on world trade, suffered in 2018 from a drop-off in global demand. When you add in all the noise from Brexit, it was enough to put many investors off from the region.”

Husselbee believes things are starting to look more positive, and with the European Central Bank unlikely to end accommodative monetary support, he sees many of the headwinds of 2018 starting to fade.

“We favour unloved and contrarian areas, and Europe fits into this. It is not all doom and gloom,” he says.

“In terms of value versus growth, growth funds have performed far better to date, but in an environment in which interest rates and inflation are set to rise, this should favour a value approach going forward. “We are currently overweight in Europe, holding three funds, with a 60/40 bias to value. Over the next 12 months, we are unlikely to increase this position unless the environment dramatically changes and Europe becomes even cheaper.”

Weighting game

Darius McDermott, managing director of Chelsea Financial Services, notes Europe is home to a number of world-class companies, that are unaffected by how the European, or indeed the global, economy is fairing.

“On this basis we would always advocate having some exposure to Europe,” he says. “On a valuation basis, Europe is cheaper than the US so we have had a reasonable allocation to it, but we have gradually been reducing our weighting.”

McDermott says while Brexit talk tends to focus on the UK economy, it will also have a major impact on Europe.

“The UK is a major trading partner for countries like Germany, so a hard Brexit will impact Europe as well,” he says. “If you factor in that Germany is on the edge of recession and Italy had two consecutive negative quarters of GDP at the end of 2018, it doesn’t paint a particularly good picture.”

When it comes to European funds, McDermott notes that all of Chelsea’s exposure comes via active funds, while also adopting a style-neutral approach.

“There are large parts of the European index that are likely to face structural challenges and disruption and that they are to be avoided,” says McDermott.

Diversification diversion

Chris Rush, senior investment analyst at Iboss, says his exposure to Europe has remained consistent for several years, with a 5% weighting split between three funds: Miton European Opportunities; Baillie Gifford European; and the HSBC European Index.

“The disparate nature of European economies and the political issues therein are well documented. However, the potential positives of European companies are, these days, overshadowed by the political drama,” says Rush.

“In fact, we have found many European fund managers are negative on their own asset class, bemoaning the overabundance of financials and dearth of large-cap technology stocks relative to the wider world. The saving grace, in their opinion, is the international nature of many European stocks.”

While these points are valid, according to Rush, they do a disservice to the role European equities play in a multi-asset portfolio.

“Much of the underperformance of European equities has occurred in the past five years, a period in which two factors have driven equity returns: namely growth stocks and, in particular, technology stocks,” he says.

“European indices are comparatively underweight both these factors and the result has been a decreasing allocation to European equities in multi-asset portfolios and passive indices.

“This means a small allocation to European equities can provide positive asymmetric diversification benefits. They offer easy to access exposure to value stocks, away from the large technology stocks that dominate US equity returns.

“Additionally, European companies are international in nature and are ably positioned to take advantage of exporting opportunities in emerging markets, for example.

“Where every investor and manager is itching to get on the US/growth/tech bandwagon, European funds are largely unable to join in and, as such, grant portfolios positive diversification benefits at attractive valuations.”

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Adam Lewis

Adam has been a freelance journalist and content editor since 2015. A journalist and editor with over 15 years experience, until 2015 he worked as editor of Fund Strategy for three years, and worked on...

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