The views expressed in this communication are those of the contributors at the time of publication and do not necessarily reflect those of Brexits Asset Management as a whole.

The need to spur on Europe’s post-pandemic recovery has initiated bold policy action. How can investors find attractive value and innovative companies in Europe?

The fast view

  • The need to spur on Europe’s post-pandemic recovery has initiated bold policy action that is supporting European equity markets.
  • Proposals for an EU Recovery Fund make the combined European policy stimulus among the highest globally. Such funding at an EU level potentially takes a step towards greater fiscal alignment and may provide relief for European financials.
  • Compared to the global financial crisis (GFC), this time around banks are part of the solution, not the problem and are key to the economy’s recovery.
  • For investors, European equity markets offer attractive value and innovative companies benefitting from the changing world that we are facing. The 4Factor approach seeks to uncover these opportunities through disciplined bottom-up analysis, currently finding a range of interesting ideas emerging from the push towards renewable energy and a digital world.

Bold moves in tough times

Over the last five years, European equity markets have underperformed global equities (Figure 1) due to political and economic issues spawned by the GFC. Fiscal austerity, a dysfunctional banking sector and low lending growth combined to produce a slower recovery in economic activity and profitability than other parts of the world. This was compounded by persistent Brexit uncertainty, political stalemates in Italy and Spain, and US-China trade tensions. Then in the first part of 2020, COVID-19 put the brakes on economic activity. Such tough times, however, have led to bold policies.

The dramatic policy response appears to have put a floor under capital markets and laid the foundations for a recovery as lockdowns ease. As part of this three-part series, we consider current developments in Europe and why they make Europe a particularly interesting region for investors now.

The pandemic has also set in motion changes that could have a profound longer-term impact on the future of European economies and markets. One of the weaknesses of the construction of the European Union has been the lack of fiscal union. The EU Recovery Fund is a small step towards greater fiscal alignment to tackle the current crisis. Such developments strengthen the depth and breadth of interesting investment opportunities in Europe and our 4Factor investment process aims to find these.

COVID-19 changes the outlook for Europe in the near term…

The pandemic had prompted analysts to significantly cut their earnings forecasts for 2020 to levels akin to the lowest point of recent recessions. However, some companies are beginning to beat these low expectations. For example, businesses with subscription related rather than transactional revenues are faring better, as are digital models such as online retail and entertainment as people become more accustomed to spending time indoors. Moreover, poor current profitability does not mean that share prices cannot appreciate in anticipation of an eventual improvement, as reflected in European equity market performance in 2012, 2013 and 2019. In the near term, it is even possible that European revenue growth could exceed that in the US. So far European containment of the coronavirus seems to have been more successful and the policy support more generous, raising the possibility that Europe could lead the way out of this downturn.

…and in the long term

Crucially, the rapidity of the profit shock has been matched by the pace and scale of the policy response. The latest manifestation of this has been the €750 billion EU Recovery Fund, representing 5.4% of EU-27 GDP, intended to support sectors and regions affected by the coronavirus. This bolsters the nearly €1.1 trillion revised long-term EU budget that represents around 1% of GDP per year, an increase of 15% compared to the previous seven-year plan.

The significance of the Fund is twofold: it provides additional stimulus on top of existing proposals, and underlines a commitment to use the EU budget as a means of raising debt to finance the spending. The latter is significant, as it could be the first tentative steps towards closer fiscal union. This would be a profound change and could address one of the issues which has hampered Europe’s growth over the past decade or more.

Efficient financial plumbing is the foundation

One of the other key reasons for Europe’s underperformance since the GFC has been the difficulties faced by the banking sector. This is now changing. Governments and regulators have recognised that banks will be impacted by the pandemic as economic activity weakens and borrowers become more stressed, and crucially understand that banks are critical to the post-COVID recovery. This time they are part of the solution, not the problem.

Since the GFC, European banks have faced a combination of headwinds which have weighed on the sector’s return on equity (ROE), both compared to history and with other regions. These headwinds have included increased regulatory capital requirements, persistently low growth and low interest rates, and elevated compliance and redundancy costs compared with other regions. This has pushed some banks to invest heavily in technology, both to reduce back-office costs and to encourage customers to migrate to lower-cost online channels (Figure 3). We believe this will remain a secular trend, given the incentive of the wide gap between the cost-to-income ratios (a measure of efficiency and productivity) of pure-play digital banks compared with traditional banks. After an initial post-COVID hiatus, several banks have resumed cost reduction programmes to remain competitive.

Accommodative regulation and policy key to recovery

Recognising that the pandemic will impact banks’ capital (via higher loan defaults and lower sovereign bond valuations as governments borrow more), regulators have proved accommodative. They have allowed banks some flexibility in capital calculations via lower countercyclical buffers, less core capital requirements within company specific risk buffers as well as tempering new loan loss accounting standards. Coupled with dividend cuts and the European Central Bank’s monetary easing programmes which lower the cost of capital for the system, this gives banks more breathing room. It will be a few quarters before the full impact of COVID-19 on the European banking system becomes visible. If one of the outcomes is that the ratchet of consistently increasing regulatory costs and capital requirements is eased to allow banks to help support the recovery, this could prove a positive for the banking sector, particularly given the sector’s depressed valuation.

Longer term, the panacea for European banks remains banking union and debt mutualisation1. With plans for an EU Recovery Fund underway, the question is whether this could lead to some form of longer-term joint debt issuance across the bloc, which could be key in lowering the cost of funds2 across the region. For the banks, more debt mutualisation could pave the way for a pan-European deposit guarantee scheme, which is the third and thus far elusive pillar of a banking union. We believe this scheme would put greater cross-border M&A back on the agenda and allow banks to consolidate cost bases, digest any bad debts and shore up profitability.

While such cross-border M&A is still some way off, intra-border M&A could still serve as an important release valve, looking to the blueprint of Spain’s banking consolidation post the 2010 crisis to improve profitability. Over a 5-year period, the number of savings banks fell from 45 to 2, the number of branches fell by almost half and banking sector profitability recovered faster than regional peers. By addressing the banking system, this lent strong support to the wider economy, which has seen Spain deliver consistently better growth than many core EU counterparts in recent years.

To conclude, we are still a long way from either banking union or fiscal union in Europe, but the importance of early steps should not be overlooked. There have been good reasons in the past why Europe should trade cheaply. We believe that the policy response to the crisis has made some of these no longer valid and therein lies the opportunity for European equities to re-rate and close their discount to other markets.

A fertile hunting ground for attractively valued companies

Even after the recent rallies, on longer-term valuation measures European equity markets have rarely been so appealing. On a price to book basis, for example, European equities have never been this attractively valued versus the US (Figure 4). This is partly due to the different sector mix of the two markets, but even adjusting for this, Europe looks relatively cheap (Figure 5). With long-term government bond yields in negative territory, equities also look compelling versus other asset classes. Even after a number of cuts to company payouts, European equities are forecast to yield 3.5%, a substantial premium even if further cuts are still possible.

Some of this value reflects the dominance of large traditional businesses in indices. Business models solely based on export growth — in Germany for example — are likely to remain challenged. Other business models may be capable of adapting under the pressure of the crisis. One of the reasons price to book value ratios look so attractive is that the index is heavily weighted to financials which remain at 30-year relative lows. Our analysis shows that as well as the cyclical discount for the rising risk of lower profitability, there is an additional discount priced in for the potential breakup of the European Union. This highlights the potential of greater fiscal alignment in reducing European equity risk, especially among financials, as well as the importance of a less onerous regulatory environment for the banking sector to lead the recovery.

The ‘new Europe’ offers diverse opportunities

To reinforce the monetary response, fiscal stimulus in many instances is taking the form of investing in projects and initiatives that will benefit the environment. Nearly a third of the recovery package has been earmarked for tackling climate change. This green agenda provides interesting opportunities for investors, which we discuss in the next part in this series. In addition, there are some secular trends in Europe that have been given extra impetus by the pandemic and are not necessarily dependent on a return to economic growth. This is explored in another instalment in our series.

This ‘new Europe’ is too often dismissed by investors, being very small in the context of European benchmarks. We regard investing in Europe as not being about countries or sectors, but about individual companies. One of the advantages of a bottom-up active approach is that we can embrace the possibilities offered by innovative businesses, while still being alert to the possibility of change in traditional industries. The 4Factor process aims to identify opportunities among both the old and the new to capture sustainable returns over the long term. With the market bifurcated between value and growth, our balanced approach enables us to find ideas across the whole market. In subsequent papers in this series, we will look at how long-established companies in the automobile industry are re-inventing themselves to meet the challenge posed by the decline of the internal combustion engine. We will also consider some of the new IT companies meeting a growing demand from consumers for cybersecurity or cashless payment systems in an increasingly digital world.