- Equity Portfolio Manager
United States, Institutional
Change
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The European equity market environment has drastically changed versus recent history, creating wide dispersion between the companies that are likely to “win” and “lose” in the years ahead. The decade after the global financial crisis (GFC) was characterised by ultra-loose monetary policy as inflation remained subdued and central banks focused on trying to stimulate growth and employment. This resulted in unprecedented price inflation across many major asset classes (public and private) and investors were able to generate very healthy and stable returns simply by holding most major financial assets.
However, we believe the next five to seven years are likely to look very different as we enter a new regime. We see three key changes:
- Structurally higher inflation and interest rates
- Different market leadership within the equity market
- Valuations are starting to matter again
This new environment is likely to drive dispersion of returns that could create the ideal hunting ground for fundamentally focused long/short investors with the potential to identify the future winners and losers.
In this piece, we dive deeper into why each of these three changes could benefit long/short investors.
Europe’s structurally higher inflation and interest rates
Tighter labour markets, demographic shifts, the energy transition and onshoring trends mean inflation is likely to be structurally higher and monetary policy structurally tighter. The result of this would be higher interest rates, and different sectors would be impacted by this new rate environment in different ways.
Banks were particularly hurt by the zero-rate environment of the recent past as it compressed their net-interest margins, but this is changing, and the 12-month forward return on equity (ROE) for the sector is now at a 10-year high (Figure 1).
Figure 1
On top of attractive valuations, many European banks went through difficult times during the GFC and subsequent years. They emerged with clean balance sheets in a stringent regulatory environment, and there are now green shoots of improving growth and ROE across the sector.
On the other hand, we expect certain business models that followed an aggressive expansion in a low-interest-rate environment, e.g., real estate, to become unsustainable at higher costs of borrowing. In particular, we observe compelling short opportunities in the property and REITs markets in Germany and Sweden. Many of these companies have increased their debt in recent years and now find themselves in precarious positions. If financial conditions continue to tighten, a scenario we think is likely, then we believe these stocks will be very vulnerable due to higher interest payments and declining property values.
Conclusion: The sharp shift from ultra-low interest rates to structurally higher ones (for longer) could lead to a reversal in fortune for many companies across Europe. This could lead to some substantial winners and (many) losers, fuelling the long/short opportunity set.
The European equity market’s changing leadership
Large regime changes typically happen every 10 to 15 years; the last one was the GFC in 2008, when growth stocks started their ascent and led the market for more than a decade. The previous one, the dotcom bubble of 2000, was exactly the opposite, as growth stocks took a dive and sectors such as energy and mining led the way.
If we look at an extreme example, in the US over the past 10 years, the S&P 500 Index has returned 185% cumulatively. However, if we strip out the eight dominant tech stocks, this return drops to 127% (Figure 2). Eight stocks therefore produced over 30% of the 500-stock index’s returns over the decade. This narrow market leadership of tech stocks is not the ideal environment for active, fundamental stock pickers. In our view, the decade to come will likely look very different.
Figure 2
The new regime in Europe could see leaders emerge in sectors that receive targeted fiscal support. While government balance sheets are currently constrained (debt to GDP is at record highs in most developed markets), the energy transition, the need to secure supply chains and increased competition between economic blocks are all likely to require significant, but targeted, fiscal stimulus and tax incentives.
We see the defence sector as one area where government spending still has space to grow (see Figure 3 below, detailing countries that have underspent the NATO 2% target of government spending on defence) following years of underspending, and events such as the Russia/Ukraine war are likely to accelerate this investment.
Figure 3
Areas that are not a “priority” of national interests are likely to be starved of fiscal aid, while others could receive unprecedented fiscal and regulatory support. This means performance dispersion could increase markedly. (Critically, monetary policy impacts every sector, but fiscal policy is often much more targeted).
Conclusion: Fiscal policy could play a larger, more targeted role in the new regime, with support for sectors such as defence and those driving the energy transition. Shorting opportunities could therefore be created in those companies and sectors that do not make the cut.
Valuations are starting to matter again
With funding costs significantly higher and unlikely to return to the low levels of the last decade, we are likely to see a reversal in some of the trends that drove stocks over the last 10 years. Valuations and positioning do not seem to reflect this new regime, with the valuation gap between growth and value still at a record high (Figure 4).
Figure 4
The consumer discretionary sector exemplifies this, in our view. For example, we believe online delivery companies’ high valuations relied on a low-interest-rate environment, with little or non-existent free cash flow and overpredicted growth. Consumers will likely look to reduce their purchases amid the rising cost of living, which could impact these companies’ earnings.
Conversely, companies with strong bottom-up fundamentals (that have been largely ignored in the growth surge of the past decade) could finally be recognised with higher valuations. For example, in the industrials sector, we see some very strong European companies that could benefit from the global move to more automation for discrete and process industries. In our view, these companies have world-leading positions in automation equipment and could benefit from this structural growth driver.
Conclusion: Valuations are starting to matter again and bottom-up stock-pickers who have a deep understanding of what is driving company valuations could be well placed to identify long-term winners and losers.
Potential risks to long/short investing in Europe
Of course, there are potential risks to this opportunity set. As in recent years, we could continue to see an environment where growth stocks outperform the market, and this narrow leadership works against long/short investors looking to profit from greater dispersion in returns.
In addition, there is no guarantee that fiscal policy in European countries will target the sectors outlined above. Government priorities evolve over time and can change dramatically based on factors such as war, natural disasters and election results.
Bottom line on long/short investing in European equities
In our view, growing dispersion in European equity markets is driving opportunities for long/short investors, fuelled by structurally higher inflation, changing market leadership and a renewed focus on valuations.
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