Given this backdrop of improving KPIs and falling unemployment, we feel it’s highly probable that European wages will grow faster than consensus believe. Should this prove to be true, then we would expect the ECB rhetoric to echo the Fed (and the Bank of England). This would mean more risk to the upside of nominal yields, consequently leading to a continued rotation in the European equity factor leadership.
Positioning: Given we continue to believe in a more sustained inflationary backdrop than is currently priced in by the market, it’s perhaps not surprising that our strategy isn’t rotating away from our cyclical biases. And even when we think about it from a bottom-up basis, this continues to be the case.
Earnings: Our team recently published another article titled ‘Don’t Give up on Earnings in 2022’. There, we mentioned that the expectations for a mere 6% European earnings growth in 2022 seemed conservative. We noted the backdrop of high savings, the services sector that’s yet to recover from the pandemic, the EU recovery fund still to be disbursed, as well as low inventories combined with pent-up capex budgets at a corporate level. We also mentioned the Autos sector, where strong demand, combined with a recovery in the supply chain and OEMs demonstrating pricing discipline, could unlock a recovery not yet factored in by the market.
Financials: Within financials, we’re exposed to the banking and insurance sector. The latter remains part of our defensive value bucket, which is covered further below. The banking sector was the second-best performing sector in Europe in 2021. However, we see them moving on from being ‘cheap for what they are’, as they became ‘investible’ again when they reinstated dividends. Now, we see them as hugely geared to the economic recovery and the demand for loans and rate plays that are driven by the green agenda. As Euribor increases in Europe, we expect to see significant bank earnings leverage.
Energy: We continue to own Big Oil, as the energy transition is creating a disequilibrium. While sustainable finance is speeding up the reduction in supply of hydrocarbons, the demand is abating only slowly. This is creating a demand imbalance and therefore sustainably higher prices. Meanwhile, European oil companies are allocating an increasing amount of capital to renewable production. This is turning them into transition businesses, which makes them investible to an increased pool of investors based on the Net Zero investment criteria.
Industrials: We believe the green agenda has altered the need for investment. Digitalisation also enabled productivity gains from low capex, while increasing operating efficiencies to supply chains. Greening the economy means we need to retool existing production assets, improve infrastructure and refurbish our property base. All these measures are capital intensive. This will be a multi-year process, creating a secular demand for industrial products and services, which we believe will lead to a sustained improvement in returns, free cash flow and earnings.
What about defensive value?
We don’t only own cyclical value in our European equity strategy. We also own defensive value. Here, we have meaningful positions in pharma, utilities, telecoms and insurance.
The companies within these sectors benefit from a more inflationary backdrop operationally, given that they have large fixed cost bases with significant depreciation charges. They lack the cyclical recovery potential of the banking, energy and industrials sectors, but they should benefit from a more normalised backdrop.
In our view, this will allow them to perform as the recovery continues to mature. Valuations remain compelling, and so, despite their earnings visibility being longer, we don’t see them as being ‘at risk’ in the rising real yield environment unlike the ‘Quality’ factor.
We don’t run value portfolios
Being overweight the ‘Value’ factor today, doesn’t mean we run value portfolios. We own ‘value’ today due to a combination of the macro backdrop, stock valuations and investment thesis creating better opportunities within that space.
We continue to hunt for ideas across the investment universe and regularly research investment opportunities within technology, luxury, medtech and consumer staples. Where we find valuation support and an interesting investment thesis, we will invest. However, we need to identify an underlying change rather than merely rely on the power of compounding – and there are various examples of this in our strategy.
For the reasons explained within this article, our team remains happy with the overall exposures of our strategy, based on the upside potential and also the inflation hedge that our positioning has created.