BLOG: How investors can benefit from policy divergence play

Written by: Tim Crockford
Tim Crockford, the manager of Hermes Sourcecap Europe ex-UK fund, argues Europe could be set to outperform the US but that investors have to take a selective approach when investing.

The European Central Bank and US Federal Reserve have reignited debate on monetary policy divergence. While hawks circle around the Fed in anticipation of a December rate hike, dovish ECB president Mario Draghi appears to have ushered in a new era of deeper quantitative easing at the recent ECB conference in Frankfurt.

The ECB supremo’s recent speech was not quite his grandstanding ‘do whatever it takes’ 2012 rally call, but he is acutely aware Europe is in a disinflationary environment and must continue to try and boost inflation expectations to avoid deflation anchoring the behaviour of investors and consumers. Currently, Draghi and the ECB find themselves running to stand still.

While the UK labour market is tightening, in the eurozone, only Germany is experiencing any tightness, and in recent months, wage growth seems to be slowing. So far, both headline and core inflation in the eurozone and UK have been running at fairly similar levels.

However there are signs the disinflation headwinds across the eurozone may soon pick up. With the rate of new lending growth across the monetary union slowing, benign food price inflation and the inflow of migrants into Europe, which could eventually increase the slack in the region’s labour markets, it is no surprise that Draghi’s tone has turned increasingly dovish.

We therefore expect the central bank to reduce the ECB deposit rate further into negative territory this December, in order to try to kick-start bank lending again.

But what this does mean for investors? 

We believe the key takeaway from a top-down perspective is that European equities could outperform US equities, as excess liquidity struggles to find a home in the real economy, and is parked into the asset markets. However, there is a major caveat here: the recovery trade that started with the 2012 Draghi speech has ended. Investors have to take a more selective approach when investing in European equities, as the market continues to narrow and those companies that can generate earnings growth re-rate.

This is reflected in the recent earnings season. We have seen more companies miss sales and earnings expectations (48%) than beat them, as earnings risk broadened over the course of the year. The main driver of misses has typically been the impact of a slowdown in emerging markets. Unlike some observers, who had expected a weaker euro to spur an export-led recovery in 2015, our consistent view has been that domestic EU consumer demand has been driving the recovery, as downwards pressure on wages and salaries has abated and lower commodity prices have increased disposable income.

Going into 2016, the oil price will be one of the main variables to watch, given the positive effect it has had on the European consumer in 2015, and we will continue to monitor whether increasing military activity in the Middle East will drive the International Energy Agency to reverse its recent forecast of a worsening glut.

Still, at this point in time it is too early to reach any meaningful conclusion and we remain sceptical that exports will take over from consumer spending going into 2016, in light of the current weakening global trade.

Furthermore, with manufacturing capacity that is far from fully utilised, we would expect fixed asset investment to remain broadly muted in all but a few emerging sectors, such as manufacturing automation, biopharmaceutical production and renewable energy infrastructure.

We take a bottom-up, long-term approach to investing, with stock selection the key driver to returns. Our emphasis is on identifying companies undergoing longer-term structural change which will benefit from themes such as these. With global growth slowing, earnings expectations being reined back and an increasingly divergent stance in monetary policy, we expect 2016 to be a year where the European market, awash with excess liquidity, rewards those companies that produce an increasingly scarce commodity – consistent earnings growth.

Tim Crockford is co-manager of the Hermes Sourcecap Europe ex-UK fund


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