Adapting in times of crisis

It is important to step back from the headlines about Europe and recognise the eurozone’s positive news, for example its recent outperformance of emerging equity markets.

Andrew Parry 160 byline
Andrew Parry

In times of crisis, companies are often forced to adapt, change and innovate. In the ongoing horror show that is Europe, there is plenty of this being done.

Since the start of 2011, European stocks have expectedly underperformed their US counterparts owing to the ongoing debt crisis engulfing peripheral eurozone countries.

But to the surprise of many, Europe has outperformed emerging equity markets over the same period.

Despite the many disappointments in Europe, there have been ample opportunities to make positive absolute, as well as relative, returns over the past few years in euro terms.

It has been important to step back from the endless stream of depressing daily headlines on the depth of the crisis in Greece, Ireland and Spain for example – and to recognise the strength of franchises and balance sheets of many European companies.

We fully believe in the well coined phrase that ‘stockmarkets are not the economy, and stocks are not the market’.

After a prolonged period of acute difficulties in Europe, the all-pervading pessimism that was evident at the start of the summer brought a number of benefits. The first was that it galvanised the European Central Bank into decisive action. Mario Draghi, the president of the ECB, categorically pledged the unwavering support of the ECB for preserving the euro at any cost.

This was followed by detailed proposals of how the ECB intended to provide unlimited funding to support the bond markets of countries that found themselves in temporary financial trouble. In effect, the ECB was proposing to become more like the Federal Reserve Board and to act as the lender of last resort within the eurozone.

The proposals from the ECB had a dramatic impact on peripheral bond yields in the eurozone, which dropped sharply as the risk of a fracturing of the euro was reduced significantly. While the move was a necessary condition for the rehabilitation of the European economy, it was not sufficient in itself to generate higher growth. However, it did provide politicians with solid ground on which to build their own policy initiatives.

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It is the politics of Europe where the most doubt remains, as there remains significant tension between the deflationary orthodoxy of Germany, where austerity is seen as the solution to all that ails the region, and the inflationary preference of the periphery of the eurozone. This tension is manifested in the marked reluctance of Spain to formally request financial assistance despite the deepening economic crisis there.

Despite these concerns, European companies (ex-financials) have healthy balance sheets and are estimated to have over €2trn in cash. Profit margins are robust and have risen over the last four years, as companies have been quick to adjust to weaker demand, reflecting a flexible and responsive corporate mindset.

Europe also has an abundance of recognised global branded companies, which is why Europe is a lot more than the crisis in Greece or Spain. Indeed, crisis often brings a hidden benefit as it forces companies to adapt, change and innovate if they are to survive. And all this can be had with a yield of 4.0 per cent on the MSCI Europe index (Bloomberg), which compares favourably with the yield AAA government bonds, A grade corporate bonds and the US equity market.

The yield premium European equities enjoy over sovereign bonds is of great long-term importance for investors – and was last seen after the Second World War when governments were pursuing expansionary and reflationary monetary policies to revive growth and to pay down a debt legacy.

With aggressive monetary intervention now being followed by nearly every major central bank in the world, with the explicit aim of raising inflation expectations, we are now in an era of suppressed returns on bonds, where real returns will only be achieved if there is a prolonged deflationary slump.

Buying government bonds, and increasingly corporate bonds, is a structural bet against economic recovery or the return of inflation. European equities already yield more than inflation and, as a long-term call on the real economy, they provide some form of inflation protection if central banks are successful in restoring a modicum of growth and avoiding a collapse into deflation.

We have rarely been an outright advocate of the asset class in which we operate, as the economic and political conditions in Europe have been far from ideal for a structural bull market to emerge. However, the rich diversity of individual companies on offer to investors in Europe has kept us enthusiastic stockpickers, as the poor market sentiment has increased inefficiency and presented many attractive investment opportunities to consider.

In a world still awash with debt, and where banks are deleveraging aggressively, there are long-term structural challenges for developed economies that will keep growth at historic sub-par levels for years to come. In such an environment, especially with widespread quantitative easing by central banks, scarce assets will be become more highly rated and certainty, financial strength, quality of franchise and cash generation will attract high valuations.

Quality European growth stocks have performed well as a consequence over the past three years, and have held their own well against the returns from other asset categories. The strength and resilience of their growth relative to the broader market has driven their strong relative performance and, while such stocks have been re-rated recently, they do not look excessively valued given the merits they possess.

While a small premium is now being paid for the most strongly-growing companies in Europe, it is still considerably below the previous high in 2008. In a world of structurally scarce growth, there is still considerable scope for quality growth companies to outperform from here.

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Andrew Parry is the chief executive officer of Hermes Sourcecap