If you had been unfortunate enough to invest in the UK market at its pre-credit crunch high in July 2007 and had the courage to hold on through the extreme gyrations of the last few years, your virtue would have been rewarded with a (modest) positive total return of almost 4 per cent.
The same is true for UK investors in the European market, where total returns are also modestly positive. However, pity the poor local European investor, who has lost 20 per cent over the same time period because he has not had the benefit of the sharp decline in sterling relative to the euro. The devaluation of sterling has maintained the value of overseas investors’ European holdings but European markets have not intrinsically recovered to the same extent as the FTSE 100.
Investors, we must deduce, have therefore given European stocks a 20 per cent discount due to the sovereign debt crisis. Now though, even the most negative Europe-watchers seem to agree that Spain and Italy do not pose a significant default threat. This leaves three relatively small economies – Greece, Ireland and Portugal – to worry about. Greece and Ireland are deep into austerity programmes which seem to be progressing more or less as planned. Adjustments may be made to the nature of the bailout packages as European bureaucrats grapple to find longer-term solutions to the fiscal ills than the present emergency sticking plaster.
However, European com- panies remain solidly pro- fitable, with the market as a whole expected to meet or beat peak earnings later this year or in early 2012. This will leave them at least as profit-able (many more so due to cost-cutting programmes) as they were in spring 2008 but apparently worth one-fifth less. We have seen global asset allocators rediscovering Europe and starting a tentative programme of reinvestment. This has further to go and, for the moment, Europe remains the cheapest regional equity market in the world.
Within Europe, the last quarter of 2010 saw aggressive outperformance from cyclical companies due to the expec-tation, then arrival of a second round of quantitative easing. Growth investors saw as much as 11 per cent outperformance of value in short order as the market expected the QE cash to rush into commodities and emerging markets. As fund managers came back to their desks after the Christmas break, they seemed to have a sudden realisation that they had neglected a huge chunk of the market and value made a sharp comeback. However, over the last 12 months, there is still significant outperfor-mance of growth, something that we also see also to a lesser degree in the US market.
It is worth bearing in mind that what we call value in Europe now tends to mean financials and those countries with exposure to peripheral Europe. Years of bad sentiment have left depressed share prices but often robust underlying earnings. Insurance continues to be a favourite sector of ours.
Marked down by association with other financials, the sector was never in as much danger as their sellers thought. It now presents an even better opportunity. After the tragic events in Japan, the market sold off insurance somewhat indis-criminately as it panicked over who had exposure to what.
With earnings season well under way, most companies are showing healthy dividend growth, with average 10 per cent increases to payouts. This could be the start of a better time for income investors. Alongside the rotation into value, many companies are sitting on huge piles of cash. Deutsche Telecom has just sold its US business for $40bn and investors are likely to get a healthy dividend. We believe this trend of shrinking mega- cap companies (long-term underperformers themselves) or the consolidation around core markets for unwieldy conglomerates could yield interesting results for income investors, with strengthening yields and special dividends.
Europe is still cheap and, after a sustained period of underperformance, income-seeking value investors could be in for a period of more generous total returns.
Olly Russ is manager of the Ignis Argonaut European income fund and enhanced income fund