European equities are looking attractive as stocks in the region remain cheap and poised for recovery, says Alan Chua (picture), executive vice-president and portfolio manager at Franklin Templeton’s Templeton Global Equity Group.
“Equity weakness in 2018 seemed to be more a function of sentiment than fundamentals. European stocks, especially cyclicals, underperformed to an extent typically associated with contraction and recession. Although [the region’s economic] growth did slow last year, composite manufacturing data remained firmly expansionary and GDP growth was positive. Looking ahead, lead indicators suggest that the European Manufacturing Purchasing Managers’ Index may be bottoming as the inventory cycle improves and euro strength fades,” he says.
“Europe’s economy remains highly exposed to global growth trends and is showing signs of nearing a trough on expectations of Chinese stimulus and a potential pause in the US Federal Reserve’s normalisation efforts. The political landscape remains highly uncertain, though 2019 will likely bring clarity on Brexit and possibly the containment of turmoil in Italy and France. Keep in mind that modern Europe has a long history of muddling through political crises.”
Chua expects quantitative tightening by the European Central Bank (ECB) to be gradual and overall policy to remain dovish given the central bank’s mandate of price stability. “With a solid dividend yield of 4% and high equity risk premium of 8% that could fall, Europe remained excessively cheap as at the end of last quarter and appeared poised for recovery following protracted weakness,” he says.
The UK government has been deeply divided over Brexit since the referendum vote result was announced in June 2016. The drama does not show signs of abating just yet, even as members of parliament continue to look for solutions they can collectively agree on.
Chua says the recent domestic response to Prime Minister Theresa May’s proposed Brexit agreement on Jan 16 suggests that the process has reached a new level of turmoil and unpredictability. “With so many political forces and special interests shaping a highly fluid set of probabilities behind the scenes, forecasting an outcome with any degree of certainty seems unwise.
“We view the UK market during Brexit as a ‘special situation’, offering potential opportunities for investors with the right approach and time horizon. Our strategy is positioned in a manner that we believe will help manage the risks and capitalise on the opportunities presented by Brexit, favouring resilient and diversified multinational corporations over domestically focused UK companies.”
China has not been faring too well either. The country recently announced that its official economic growth last year stood at 6.6% — the slowest pace since 1990. Meanwhile, the International Monetary Fund said China’s sharper-than-expected economic growth is one of the two biggest risks to global economic growth in 2019.
Chua says the impact of trade disputes and economic imbalances are becoming apparent in softer economic data. Nevertheless, there are still opportunities to be found in selected counters.
“While officials will continue to pursue a more sustainable economic model by deleveraging, de-risking and closing excess capacity over the long term, short-term pressures will probably necessitate easier policy in 2019. From an investment standpoint, Chinese companies still offer an attractive combination of high organic growth and cheap valuations, though opportunities are selective. To this end, we have largely avoided state-controlled industries plagued by excess leverage and capacity, focusing instead on lowly valued consumer- and service-oriented sectors that are likely to capture an increasing share of China’s future economic growth,” says Chua.
Across the board, he sees scope for continued moderate global growth as China likely eases while the Fed and ECB manage their respective economic cycles. “Volatility is likely to remain elevated, given rising late-cycle risks, but dislocations present opportunities for disciplined stock-pickers. While valuations look extended in some parts of the market, we also see pockets of opportunity, particularly outside the US.”
Chua believes that a renewed economic cycle, weaker US dollar, higher yields globally and valuation mean reversions will help value stocks outperform in the coming year. “At end-2018, global value stocks were trading at a 45% discount to their historical average relative to price-to-free cash flow multiple and a more than 25% discount on relative price-to-book value. On price-earnings ratio, international value stocks was the cheapest relative to growth since the depths of the European sovereign debt crisis,” he says.
Chua favours the financial and healthcare sectors going forward. “We continued to gradually reposition our financial sector portfolio in 2018 to rationalise holdings and reduce concentrated political risk,” he says.
“Unlike other defensive sectors, healthcare is less of a simple bond proxy, offering defensiveness independent of rate fluctuations. The sector also offers above-average growth through innovation and untapped market potential. At end-2018, the industry was generating higher profit margins than the overall global market with lower-than-average leverage ratios.”