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The misconceptions of Europe that need to be revised

29 October 2018

FE Alpha Manager Niall Gallagher says Europe is in much better shape than it has been for many years, but investors remain reluctant to invest.

By Jonathan Jones,

Senior reporter, FE Trustnet

UK investors who believe Europe is a low-growth, overly-domestic market are misunderstanding the market, according to GAM Investment Management’s Niall Gallagher.

The FE Alpha Manager of the GAM Star Continental European Equity fund said the region is much more interesting than it has been made out to be by investors.

“The first point to make is that the European economy – despite what we read – is actually growing quite quickly at around 2-2.5 per cent a year,” he said.

EU annualised GDP growth from 2000 to 2017

 

Source: World Bank

While this has slowed during 2018, it remains at an elevated level relative to its recent history and is among the healthier rates of growth seen globally.

This can be linked to lower unemployment, which is now coming down quite quickly in formerly problematic areas such as Spain and Italy.

Importantly, Gallagher said, youth unemployment is also coming down as well. Younger people are more likely to spend than save, which is good for consumption. This is also having a positive impact on wage growth.

“The underlying European economies are doing relatively well and that includes places like Italy which is controversial given what we are seeing today. The Italian economy has up until now performed quite well,” Gallagher said.

However, investors remain unimpressed as despite the positive numbers it has lagged behind the US for quite some time. But this, the FE Alpha Manager argued, makes for a reason to look at Europe again.

“The economy took a lot longer to recover than the US. We went from the global financial crisis to the rolling series of the eurozone crisis and it is only over the last five years that we have seen a recovery begin to take place,” he said.

This has also impacted valuations, with the US market now about 50 per cent above peak when compared to the peak of the previous cycle.


“In Europe we are 20 per cent below the previous peak but earnings growth has accelerated at about 8-10 per cent a year and we expect this to continue, so there is a pretty decent fundamental environment for what we see in Europe,” the manager noted.

This has been reflected in the stock market, with the S&P 500 up 349.54 per cent over the last decade, while the Euro Stoxx index has returned 149.2 per cent.

Performance of indices over 10yrs

 

Source: FE Analytics

Currently, the European market trades on a price-to-earnings (P/E) multiple of slightly more than 13x with a number of stocks on single-digit P/Es.

“These often have no debt, run balance sheets with fair amounts of net cash, high return on capital employed, decent free cashflow yields but for whatever reason are cheap,” Gallagher said.

“There are pockets of activity that are growing nicely but they are coming from very depressed levels and there are certain parts of the economy such automobiles or construction where we are probably only two years in to what will be a long cycle.”

Another misconception is that when investors buy Europe they are limiting themselves to very domestically-orientated companies.

However, Gallagher said there is much more to the market than just the trade within the European bloc. Indeed, around half of the revenue within the asset class is derived from outside of Europe.

While domestic earnings recoveries in Italy, Spain, Portugal and Ireland are all positive, even more crucial is the health of the emerging markets, where almost 40 per cent of earnings now come from.

“In many respects, you get exposure to some of the most dynamic and growing parts of the global economy, which we think on a decade view or perhaps longer will be the driving force of earnings growth, in Europe,” said the GAM Star Continental European Equity fund manager.

Of this 40 per cent from the emerging markets, a big chunk is from China, with a number of high-profile companies now more reliant on China than any other market.

“For a lot of our companies China is either the first or second-most important market,” Gallagher said, noting the auto manufacturers as an example of a sector that is benefiting from this relationship.

“I think this combination of a recovering Europe and more long-term the secular growth from emerging markets, means that the asset class is much more interesting than it is often assumed to be,” he said.


One black mark on the region, where investors are unlikely to see a resolution to market volatility in the next few months is Italy, according to Gallagher.

The populist coalition government, headed up by prime minister Guiseppe Conte “are looking for a fight with the eurozone authorities and particularly the Commission,” Gallagher said, who have no real incentive to back down with European parliamentary elections coming up in May next year.

“We saw that the EU Commission has asked some questions on the Italian budget which led to bond yields in Italy rising and I think this [volatility] could carry on,” he added.

The market is more likely to discipline Italy more than the European Commission will as bond yields and bank funding costs rising will cause some damage to the stock market.

But this means that the underlying economy should remain on reasonable footing.

Gallagher said: “While we can’t ignore the fact that they have a government that is populist and apparently looking to pick a fight with the EU authorities, the underlying economics of Italy are not as bad as they have been made out to be.

“When you look at the figures the Italian economy is running a current account and primary budget surplus and it has one of the largest savings rates in the world at more than 10 per cent.”

 

Gallagher’s GAM Star Continental European Equity fund is neutrally-positioned on Italy currently, reflecting the balance between good fundamentals and worrying politics.

Overall, he is overweight the EU domestic economy, rather than those companies deriving their earnings from the emerging markets and overseas, with around 60 per cent of earnings from Europe.

Performance of fund vs sector & benchmark over manager tenure

 

Source: FE Analytics

Since he took over the fund in 2009 it has returned 112.11 per cent, beating both the IA Europe Excluding UK sector and MSCI Europe ex UK index, as the above chart shows.

The four FE Crown-rated fund has a yield of 1.11 per cent and a clean ongoing charges figure (OCF) of 1.04 per cent.

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