Europe under the spotlight

Sam Morse - Portfolio Manager
1 November 2018

After a slight recovery of markets during the second quarter of the year, the overall market tone has remained cautious and there is uncertainty about the outlook in many directions. The ongoing trade wars with no apparent end in sight, the regulatory tariffs coming into effect, the squeezing of company margins due to pressures from input prices and wage inflation all leading to a combination of negative sentiment.

Generally, there is a concern that the profit cycle may be peaking. Dispersion in valuations has grown with less favoured parts of the market such as automotives and financials looking very “cheap” if you assume that earnings hold up. Mergers & acquisitions continue to raise corporate leverage, particularly in the US.

US government bond yields have risen after the September Fed minutes. Markets have sensed that the US Fed (and maybe the European Central Bank too) will normalise policy more quickly than expected to generate some monetary firepower before the next crisis arrives. This has triggered a sharp decline in global equities coupled with a rotation away from ‘expensive’ growth towards ‘defensive’ value. Is this the beginning of the end of this stock-market cycle or just another healthy correction in a long bull market?

Earnings, although still growing year on year, are being revised down somewhat as commodities and input prices continue to rise. Margins are being squeezed, especially for companies without pricing power. Brinkmanship has been the strategy of choice in many areas of negotiation be it trade wars or Brexit; inflicting on investors the prospect of binary outcomes and the discomfort of frayed nerves. It is no surprise therefore that volatility is high.

Against this uncertain backdrop, selectivity is important and I remain focused on identifying attractively valued cash-generative companies with strong balance sheets, which have the potential to grow their dividends consistently over a three to five-year period. History shows that these types of companies perform strongly over the cycle and we expect this to continue going forward. 

At the sector level, I am finding a number of these types of opportunities in areas like health care and also financials. Roche remains a key holding in the portfolio. The company is likely to benefit from its newly launched products and should be able to offset any negative impact from biosimilar entrants. It also has a strong drugs pipeline, which bodes well for the stock. I also like Sanofi, which is trading at an attractive valuation with good growth prospects in its new focus areas. It also has a new chief financial officer, which has raised the prospects for cost-cutting initiatives. 

Elsewhere, I continue to like Deutsche Boerse as it has a solid balance sheet with a stable revenue stream and good growth prospects. It is also benefiting from two cyclical drivers: increased volatility and rising US interest rates. I am also positive on Intesa Sanpaolo given its attractive valuations and strong growth prospects.


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