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Neutral ground

There has been somewhat of a stabilisation in European equities over the last month. In early March, markets dipped to a level 58 per cent below the 2007 high. Since then, they have bounced by 14.5 per cent and stand today around 6.5 per cent higher than one month ago.

Like other equity markets, the recent rally has neutralised the very oversold position reached in early March and we now sit at or near technical resistance levels. Last month’s investor fear, driven by consumer retrenchment, contracting economies, deflation and unemployment, has been rapidly replaced by some hope that the stimulus measures will eventually feed into the real economy.

It is notable that, in particular the focus of concern has turned from deflation back to inflation, the lesser of the two evils. Consequently, the revival in markets has seen a distinct change in leadership at the sector level. Since the low of March 9 (to close Monday, March 23) the banks and insurance sectors have risen by 44 per cent and 38 per cent respectively (versus the market +14.5 per cent) while the healthcare and food and beverage sectors have barely managed 35 basis points between them.

The only other outperforming sector has been basic resources (+23.5 per cent, +9 per cent relative). Given the extent of the falls seen in the last six months, it is unlikely that we will see these relative trends abating soon in the absence of any further economic shocks.

Economic conditions are certainly dire but arguably not getting any worse. For now, we seem to have averted any further breakdowns in the banking systems through implicit (and some cases explicit) underwriting by sovereigns.

Quantitative easing has begun, rights issues have taken place and for now disaster has been averted.

While much of this activity has taken place outside Europe ex UK, the knock-on effects for sentiment for European financials has been considerable. Threadneedle European ex UK portfolios have been actively buying financials over the last month and today the average portfolio is neutral. Outside of financials, considerable hope is being pinned on the short-term effects of restocking, plus a resurgence in Chinese growth during 2009.

The tail-end of the 2008 earnings’ season did not offer any further negative surprises. A number of rights issues have taken place, notably Lafarge, St Gobain, CRH, Enel and Gas Natural.

Capital raising in the financial sector has typically used hybrid instruments. Many companies have refused to give any short-term outlook and as such dividend policies have been under greater than usual scrutiny.

We can find many solid companies where their equity yields more than the debt. Typically, these companies have underperformed the recent bounce but we remain committed for the long-term value and growth that they offer (for example, Nestle, Danone, Roche, Sanofi).

The increase in our financials weighting has typically been funded by a reduction in our industrial weighting, where we believe that the market continues to discount over-optimistic top-line and margin performance.

In what is likely to be a bear market rally, we currently sit at a crossroads – the obvious (in hindsight) trades from a sector perspective have neutralised as extreme negative sentiment has eased.

Fundamentally, we feel that financials are unlikely to fall further versus the market as authorities succeed in getting toxic assets off corporate balance sheets. With regard to financials, rather than say that we like the sector, it would be truer to say that we dislike them a little less.

Growth in the financial sectors remains a rather abstract concept. Deflation would seem to have been averted and we would rather get our beta from bombed- out financials than expensive industrials. For now, we are happy to have a more neutral stance and concentrate on stockpicking within sectors.

Dan Ison is fund manager of Threadneedle’s pan-European Accelerando fund


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