Will European Stock's Challenging Start to 2016 Continue?

Despite a promising end to 2015, the disappointing performance of European equities in recent years has been carried through to 2016

Muna Abu-Habsa 20 April, 2016 | 11:06AM
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Only a few months into the year and 2016 has already lived up to the billing that it would prove to be a very challenging year for investors. The disappointing performance of European equities in recent years has thus far been carried through. That is despite a rather promising end to 2015. Sadly though as the year drew to a close so did the rally. Europe’s decline this year has been broadly-based, with all the main markets falling in unison as did most of the sectors.

Despite those headwinds, it is not all gloom

The downturn was indicative of general profit-taking following a strong rally during the fourth quarter of 2015. Indeed, the scale of the rebound in October, 7.1% for the MSCI Europe ex UK Index in US Dollar terms, ensured that that even a weak December could not prevent strong returns for the quarter overall.

It is slightly rosier picture for the sector in relative terms though. The average fund in the Morningstar Europe ex UK Large-Cap Equity category significantly outperformed the MSCI Europe ex-UK index in 2015, delivering a return of 3.3% in USD terms whilst the index struggled to remain above water, losing 0.65%, and follows three successive years of outperformance by the average fund.

There was also a significant difference in terms of returns over the year as a whole when comparing funds by their market-cap focus, with the average fund in the Morningstar Europe ex UK Small/Mid-Cap Equity category returning 10.5%. Although the fortunes turned this year, funds with a smaller-cap tilt have shown slightly more resilience than their large-cap-biased counterparts when compared with the index.

January’s financial market turbulence turned into a veritable storm in the early days of February with extreme moves and volatility in all asset markets. Crude oil suffered its biggest two day plunge in seven years, bond yields collapsed and financial stocks led substantial falls in European equity markets. Although this partly reflects increasing investor uncertainty and anxieties over growth, oil and central bank policy, some speculative trades in far less liquid financial markets have amplified the volatility.

Investor concerns were initially driven by a U.S. slowdown, Chinese developments and the implications of further commodity price falls. However, more recently there has been a shift towards anxiety over growth in developed markets and heightened fears over the developing signs of financial market distress, particularly in corporate credit and the financial sector.

Against this backdrop of uncertainty, the probability of a global recession has risen, spreading fear in equity markets and potentially creating feedback loops that could become self-fulfilling. It appears that another risk-off phase has spurred buying of government bonds and heavy selling of equities as earlier uncertainty has morphed into increased recession risk.

Europe: Reasons to be Cheerful?

Despite those headwinds, it is not all gloom. In fact, there is enough evidence to suggest cyclical forces are still supportive with unemployment falling at its fastest pace since 2007, auto sales are recovering, credit growth improving and consumers’ major purchase intentions are close to their highest level since early 2001. Moreover, the latest PMIs and regional and industrial country survey data all remain at solid levels.

At a sector-level, volatility in energy has been extreme. Having lost significant ground last year, the sector has come back strongly this year. Indeed, Lundin Petroleum and Statoil are amongst the best performing stocks in the index. Oil price rallies have been led by rumours of possible production cutting deals between Russia, Saudi Arabia and other OPEC members. Many commentators expect a rebound towards the end of this year and into 2017. Nevertheless, the average fund in the Morningstar Europe ex UK Large-Cap Equity category remains underweight in energy. This is in keeping with findings from our analysts’ recent review of European equity fund managers who remain largely cautious on the sector’s prospects.

Somewhat unsurprisingly, given the uncertain market environment and recent financial market concerns and turmoil, precious metals are back in vogue. Most commentators remain agnostic on gold from a fundamental perspective but recognise the upside risk due to the recent financial market turbulence. Safe-haven attributes, therefore, may continue to be supportive for a while longer.

Battered Banks Pull Down Markets

On the other hand, financials have been battered this year and in particular European banks, which have featured at the bottom of the performance tables. Credit Suisse, Deutsche Bank, Bank of Ireland, Societe Generale and Intesa Sanpaolo, amongst others, are down in double digits. It is no surprise that the average fund in the Morningstar Europe ex UK Large-Cap Equity category is underweight in the sector.

Earnings for European banks continue to be weak, with average return on equity still below cost of equity –this is despite several cost cutting and rationalisation initiatives in recent years. Headwinds from emerging market and commodity weakness, as well as the change in the regulatory environment in relation to capital requirements, have added further pressure. Whilst it is important to remember the crucial role of the financial sector in aiding both an economic and market recovery, it is somewhat reassuring that this is at the forefront of policymakers’ thinking.

Indeed, Benoît Cœuré, Member of the Executive Board of the ECB, noted recently in a speech: “The euro area is still recovering from a once-in-a-generation economic and financial crisis that has left deep scars on the economy. It urgently needs higher growth to bring down high unemployment, to deleverage the economy and to raise inflation back to our price stability objective. Uncertainty in the financial sector only blocks that path”.

A version of this article appeared in International Adviser magazine

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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About Author

Muna Abu-Habsa  is a senior investment research analyst at Morningstar