sA persuasive argument for investing in European funds is their diversification. Although the underlying economies are lumped together they are a heterogeneous group, with economies as diverse as Germany’s mammoth mechanical engineering industry and energy-supplier Norway, with its smaller population than Greater London. This spread offers relative immunity from the cash-strapped consumers of the US and UK, together with access to many truly global stocks.
European companies frequently deliver global reach without the full volatility of pure emerging market plays. Cedric de Fonclare, who runs Jupiter European Special Situations fund, says Europe has been the main beneficiary of globalisation because low growth in domestic markets in countries like France and Germany created an incentive for companies to expand, and they have also been able to take advantage of immigration from Eastern Europe which has lent flexibility to otherwise rigid labour markets.
The European fund umbrella further diversifies risk away from the overstretched consumer of the UK, and to a lesser extent Spain and Ireland. In Germany, for instance, 10 per cent of monthly income finds its way into personal savings. Arguably, it was stronger household balance sheets across the Continent that allowed the European Central Bank to get to grips with inflation in July, raising the rate on the marginal lending facility by 25 basis points to 5.25 per cent.
“At the moment the big fear is that policymakers in the UK and US are so constrained by high inflation that they can’t act to help the economic outlook,” says Raj Shant, manager of Newton’s Continental European and European Higher Income funds.
“It may seem perverse to say so, but the European Central Bank (ECB) is doing a terrific job by raising rates,” he explains. “In Spain or Ireland you might think this was insane, but inflation is the key issue and it’s been part of the equity market reaction since the credit crunch last year. Inflation will begin to moderate and I believe we’ll see 12-18 months of growth in Europe, albeit at a slowing rate.”
The ECB’s rate rise divided the market, however. “From a sentiment perspective the US Fed has been acting aggressively to defend growth whereas these guys at the ECB are myopic in their adherence to policy and attention to short-term inflation data,” argues Luke Stellini, product director, European Equities at Invesco Perpetual.
“We now know GDP second quarter numbers were in negative territory. In my opinion raising rates was a mistake, a blunder that (Jean-Claude) Trichet’s subsequent hands-up speech seemed to acknowledge. I’m not convinced there need be such a firm hand against wage inflation,” he adds.
“The way I’d describe the market at the moment is a real state of flux,” says Mr Stellini. “The commodity breakdown and dollar recovery have marked a line in the sand.”
The unwinding of ‘long oil/short banks’ positions temporarily buoyed the market in the second half of July and helped alleviate fears of rising inflation, and a strengthening dollar also reduces the appeal of commodities. But it is too early to determine whether investors are abandoning commodities or just taking profits, and managers are still hoarding cash until visibility improves.
Banking woes
As we went to press, the financial sector continued to be hit by rumours about the state of Lehman's balance sheet and the prediction from former IMF chief economist Kenneth Rogoff that a large US bank will fail in the next few months. Some managers are picking off stocks such as BNP and Crédit Agricole with a slightly different model that they feel may be oversold. One country where banks have done fairly well is Italy.
“Whether it is a lack of business acumen or down to great foresight or wisdom, most Italian banks have not invested much in subprime toxic waste,” says Philippe Brugère-Trélat, lead portfolio manager on the Franklin Mutual European Fund, adding that banks such as Intesa San Paolo and Banca Popolare Italiana “enjoy the benefit of a strong and very profitable domestic retail banking business”.
The Henderson Pan-European Equity fund’s relative success over the year is partly a result of its underweighting in banks. Bill Stormont, who supports manager Tim Stevenson at Henderson, points out that other managers have acted on false signals that the banks have hit the bottom and could be about to recover, citing JPMorgan’s purchase of Bear Stearns in March and the UBS rights issue “where the hope in the wake of a results or other major announcement was that the bad news was out of the way.
“We’re not prepared to guess at this when the banks’ own CEOs aren’t able to tell us when the next data point will be, so we are standing back until the valuation argument is in their favour,” says Mr Stormont.
