We believe we have entered a mature stage of the financial cycle amid central bank monetary policy normalisation (more advanced in the US) and decelerating economic growth globally. Protectionist dynamics are also features of this phase of the cycle, while the US fiscal expansion and a capex revival are all forces working to extend it.
The move to a late stage of the cycle is leading to a tightening in liquidity and financial conditions and to potentially more frequent episodes of volatility spikes, such as the one experienced in February. Market swings in 2018 have been the result of this new, less complacent and less directional market, which we expect will continue.
In 2018, investors have so far been more cautious on European equities. In fact, while valuations remain relatively compelling, multiple political risks weigh on the appetite for this asset class. In the short term, a series of events will continue to create noise on European assets: country-specific political deadlines, the continuation of trade disputes at least until the US mid-term elections in November, the starting of the campaign for the 2019 European parliament elections and the Brexit negotiations.
With the uncertainty led by this news flow, we believe that European equities are starting to offer pockets of opportunities, especially for stock picking investors. We think that 2019 could mark a comeback to this asset class as global investors reassess the equity opportunities in the markets, with a stronger focus on the quality of companies, diversification of their portfolios and avoiding crowded and overvalued areas. When this occurs, we think that a focus on quality companies that are able to deliver sustainable earnings growth in the future and that are trading at discount levels will be key to exploring market opportunities in Europe.
In our view, the most likely global scenario for the next 12 months is consistent with still-above-potential economic growth, but with it probably peaking and being exposed to vulnerabilities (protectionism and geopolitical risks). With this backdrop, the outlook continues to be positive for earnings globally and in Europe, but with a more balanced growth profile among sectors expected for 2019, hence calling for an increased focus on stock selection within sectors. Looking at valuations, Europe looks relatively attractive – with the price/earnings ratio of MSCI Europe falling well below the 20-year average after a volatile first half of the year.
Key variables to watch in stock picking in Europe will be the currency dynamics and the interest rate outlook. On currency, even if fundamentals continue to support the appreciation of the Euro on a 12-month basis, significant short-term uncertainties remain in place. While the shorter-term volatility in the currency may affect certain names and sectors (such as exporters), we see the underlying economic strength outweighing any currency volatility. The interest rate outlook, with the ECB gradually exiting the ultra-accommodative monetary policy, could benefit value themes and the financial sector, a key sector in Europe. Here selection remains paramount as the sector is undergoing a profound transformation driven by increased regulation.
With still significant dispersion among stocks in Europe, investors should consider embracing an active bottom-up stock picking approach to identify the companies that are better positioned to deliver sustainable earnings growth in this environment. A focus on healthy balance sheets and clear and sustainable business models, plus putting in place appropriate
margins of safety while focusing on attractive valuations, will be key to investing in European equity markets going forward.
