Europe: “Banking” on Volatility

There were plenty of reasons for optimism in the early months of the year.

Europe exited winter largely unscathed by the energy crisis. China had finally moved on from “Zero Covid” and reopened its borders. Earnings momentum in 4Q22 numbers was surprisingly supportive. Valuation remained cheap, particularly relative to US peers. And all of this provided a good foundation for foreign investors to rebuild equity positions in the region, pushing the CAC 40 and FTSE 100 indices to record highs.

However, Europe’s bright start was brought back down to earth by a new concern: the banking sector. Silicon Valley Bank’s collapse in the US and the demise of Credit Suisse in Switzerland left the market on edge with talk of contagion. This was despite the fact that European banks are better regulated and maintain stronger balance sheets than they did during the Global Financial Crisis. Credit Suisse reluctantly fell into the arms of UBS and the market surveyed the sector for potential future casualties. For investors who had embraced a soft-landing narrative for Europe, the bank-led volatility was a rude awakening that market challenges could still persist. Although we will continue to monitor events, we believe sector concerns were overdone, with market concerns driven by idiosyncratic company-specific issues.

The volatility also dented cyclical stocks’ outperformance early in the year, leading to investor rotation into more defensive areas. It wasn’t just the banks that struggled. Energy stocks came under pressure during the period amid oil price weakness, while auto stocks declined on concerns about waning demand. And there were signs that the consumer is feeling the pressure, as reflected in the weak sales update by one of the world’s largest fast fashion groups.

Still, concerns about a more extensive fallout have not gathered momentum, thanks in part to the confident messaging by the authorities. It took an outbreak of global financial sector turmoil for the European Central Bank (ECB) to finally embrace the “meeting-by-meeting” rate policy approach, suggesting more data dependency. That will give the ECB more flexibility as it navigates an increasingly complicated backdrop.

ECB President Christine Lagarde stated that the ECB “stands ready” to provide emergency support for eurozone lenders in the wake of Credit Suisse. The comments came as the ECB pushed ahead with a 0.5 percentage point increase in interest rates, taking borrowing costs to their highest level since 2008. Inflation remains the focus. “We do not see clear evidence that underlying inflation is trending downwards,” Lagarde said. “Bringing inflation back to 2% over the medium term is non-negotiable.” (Source) The obvious takeaway was that policymakers did not deem the financial sector turmoil as likely to destabilise the euro-area economy, which is a positive for equities. We expect two more rate rises that would take us to a terminal rate of 3.5%.

Given the environment, we still see value in taking a diversified approach that encompasses exposure to defensive names, companies providing good shareholder returns, and stocks with inflation-hedging qualities.

Indeed, much to the market’s satisfaction, European companies have announced more share buybacks in 2023 than in the pre-pandemic period. For the year to 20 March, 72 companies announced new buybacks worth EUR80 billion in total, versus net share purchases of EUR77 billion for the same period in 2019. The financial sector has so far the highest number of buybacks, with 19 banks and seven insurers announcing approximately EUR31.5 billion (see Chart 1).

The STOXX Europe 600 trades at a 2023 forward price-earnings ratio (P/E) of 12.9x, a significant discount to the S&P 500’s 18.8x, while also outperforming its US peer (8.7% vs. 7.0% as of 10 April 2023). In addition, dividend yield remains a positive quality for European stocks (3.4% for STOXX 600 vs. 1.7% for S&P 500).

With valuation multiples still looking attractive, accompanied by a more supportive earnings picture, European stocks remain favoured.

Read European Equity Perspectives Febriary-March, 2023:  Europe: Showing New Year Resolve 

UK: Still Offers Value Even If Lagging

The FTSE 100 posted a record close in late February 2023, crossing the 8,000 mark for the first time ever. Yet that has not been enough to stop the index and UK stocks in general from lagging their regional peers on a year-to-date basis. Indeed, as of 10 April 2023, the FTSE 100 had only risen 3.9% year to date, trailing the STOXX 600’s 8.7% advance.

The FTSE 100 had been a go-to market in 2022, but the index’s defensive merits have found less appeal so far this year. The UK’s challenges are well known. The country continues to battle a cost-of-living crisis that is potentially harsher than elsewhere in the region, while the economy remains bruised by the 2020 exit from the European Union and last year’s domestic political turmoil.

While some domestic plays did experience a relief bounce, the UK consumer could still struggle in the face of the staggering impact of rising interest rates. UK bank lending standards are tightening, and demand for credit is moving lower. This April also marks the end of the Energy Bills Support Scheme, which saw GBP400 taken off consumer bills from October 2022 to March 2023. Meanwhile, the average home will face an annual bill that is GBP285 higher than the previous 12 months, according to the think tank Energy and Climate Intelligence Unit.

Retail names are starting to feel the impact of  pressures on the consumer. Shares of a UK-based multinational retailer, which is a bellwether for the country’s retail sector, plunged after the company warned of a challenging year ahead and repeated that profit and sales will probably decline this year. The company cited a combination of inflation in the cost base and weaker top line sales.

But it is not all doom and gloom for the UK.  Economic activity data has been stronger and the outlook for real household income has improved. This year’s Spring Budget suggested a brighter macro outlook and contained new stimulative measures worth GBP90 billion over the next five years. Prospects of more fiscal support along with falling energy prices have brightened the outlook, which in turn should support UK domestic names, which have seen sharply negative earnings-per-share revisions year to date. Travel is poised to remain a consumer priority, as an airline group said recently that bookings were holding up. In addition, UK companies’ revenues beat estimates by 2% in the last earnings season.

Inflation is still an issue – February 2023’s data surprised to the upside at 10.4%, up from 10.1% in January 2023, the first increase in four months and versus expectations of 9.9%. But despite the recent financial market volatility, the Bank of England has not been distracted from its focus on fighting inflation, raising interest rates by 25 basis points. The central bank also expects the pending recession to be shallower than previously forecast.

The UK offers deep value with a defensive bias. The market has a high weighting in energy, which is defensive at this stage of the cycle. In addition, the market still offers dividend yield attractions, an important element in a rockier macro environment, with the FTSE 100 yielding 4.2%. We maintain our current preference for UK names with international exposure.