Pricing power and balance

Portfolio managers Sam Morse and Marcel Stotzel review the challenges and complexities facing investors in Continental European equity markets. As the outlook across the region remains precariously balanced, they discuss why they believe a balanced portfolio of sustainable dividend payers with strong pricing power has the potential to navigate a challenging macro backdrop.

What is your investment outlook for 2024 given the prevailing macro environment?

The prospect of recession has loomed over the global economy for much of 2023. Whilst there was a hope that inflationary pressures would ease, allowing central banks to begin to unwind monetary policy before the global economy deteriorated further, 10yr US bond yields at 5% have dented that prospect. Inflation may have halved year-on-year in Europe, but prices are still rising at a mid-single digit rate. Looking ahead to 2024, there continue to be signs that, both in Europe and globally, further challenges lie ahead.

Sovereign bond investors now seem to be worrying about levels of debt and deficits as much as prolonged inflation. The degree of leverage facing corporates is another area we are cognisant of, given that the real impact of the higher rate environment has not yet been felt by those benefitting from low fixed rate debt. Geopolitics continues to dominate, whilst Saudi production cuts, industrial action in Australia and the threat of a cold winter will likely drive oil & gas prices higher.

Consumer spending, the main component of GDP in the West, held up remarkably well in 2023, buoyed by pandemic savings, a robust stock market and higher interest rates on deposits, but investors sense that the outlook is less rosy. Overall, global economic growth appears to be increasingly anaemic and we would expect aggregate growth expectations to come down further heading into 2024. In such an environment, we will be even more focused on the underlying characteristics of the companies in the portfolios.

What do you think could surprise markets in 2024?

In terms of surprises for 2024, we may have already entered a period of stagflation; a time when nominal economic growth will not result in real economic growth, when nominal gains in the stock market will not compensate investors for their loss of purchasing power. Our strategy to combat this will be to identify businesses with strong pricing power and to avoid companies with stretched balance sheets. ‘Higher for longer’ may also continue to pressure long-duration growth (the denominator effect) and we will be cognisant of that in maintaining our balanced approach.

Valuations generally are not expensive but, again, ‘higher for longer’ appears to be the path central banks will take and this will likely keep a cap on any rerating. Our continuing focus on well-funded and cash generative companies which can grow dividends consistently should also give us added protection if we enter a more recessionary environment.

What has worked well in your portfolio over 2023?

2023 has been a mixed year for performance. The portfolio delivered very strong outperformance relative to its benchmarks over 2022, so it feels natural that a portion of this outperformance would be returned in 2023. In keeping with our investment process, stock picking has been the main driver of returns year-to-date. The use of leverage and shorting has been a net positive to relative performance when looking at Fidelity European Trust PLC.

At a stock level, the standout contributors have been Novo-Nordisk and 3i Group. Healthcare firm Novo-Nordisk has delivered consensus beating growth driven by higher demand for its weight loss drug Wegovy and diabetes drug Ozempic in the US. Meanwhile, private equity group 3i Group has benefitted from solid underlying performance in its investment portfolio, despite the challenging macro backdrop.

Where are the key areas of opportunity in 2024?

Our portfolios remain balanced in terms of sector positioning and our focus is on finding attractively valued companies with good prospects for cash generation and dividend growth over the longer-term. Our positioning is driven by opportunities at the individual stock level rather than by macro developments, as we believe that calling the bottom of the market is a difficult and often impossible task.

We have, however, started to cautiously increase our exposure to some companies that have performed poorly recently and now look particularly attractive. This includes companies where we see superior pricing power and balance sheet strength, which should make them relatively resilient to a weaker economic backdrop. Conversely, we are wary of companies that have historically demonstrated limited pricing power and are therefore more exposed to margin pressure, as well as those that are overly leveraged and could struggle as interest rates continue to be ‘higher for longer’.