Snapshot: Europe shines but any setback could be fierce

Europe has been the black sheep of the investment world for a number of years, yet in the past 12 months European equities have been the clear winners in terms of performance.

The IMA European Smaller Companies sector has outperformed its larger counterpart with a return of 18.96 per cent for the 12 months to May 12 2014, compared with 11.45 per cent from the IMA Europe excluding UK sector, according to FE Analytics.

Smaller companies typically do better in times of economic growth and recovery and the performance of the individual funds show that many managers are taking advantage of this, with even the worst performing fund in the sector posting a positive return of 7.1 per cent for the year to May 12, compared to the 1.73 per cent loss from the bottom fund in the IMA Europe excluding UK sector.

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At the top end of the scale the best performing vehicle across both the IMA European Smaller Companies sector and the IMA Europe excluding UK sector is the £75.5m Ignis European Smaller Companies fund run by Ian Ormiston, with a 12-month return of 34.39 per cent. This is almost four percentage points higher than the top-performing IMA Europe excluding UK fund – Schroder European Alpha Income – which delivered a return of 30.96 per cent.

Not only have small caps been dominating the returns in Europe, but both sectors have outperformed last year’s success story, the US. The IMA North America sector is currently lagging its European counterparts significantly with a 12-month return of just 6.29 per cent.

The economic backdrop, although it has no direct correlation to what happens in stockmarkets, does appear to be boosting confidence in the European recovery story. Consequently, inflows into European funds have increased compared to the same periods in 2013.

In March 2014, the IMA European Smaller Companies sector recorded net retail sales of £67.4m compared with £48.4m in March 2013, although interestingly the IMA Europe excluding UK sector is slightly less popular with net retail sales in March 2014 of £36.7m, marginally below the £40.6m recorded in March last year.

With interest rates remaining at record low levels and the peripheral economies starting to see signs of a sustainable recovery – for example, Standard & Poor’s upgraded its ratings outlook for Portugal from negative to stable in May – the outlook for the region could be considered optimistic.

But there are some dark clouds on the horizon that could, if left unchecked, lead to some potentially serious storms. The most obvious of course is deflation in the eurozone, but with Mario Draghi signalling in March that the European Central Bank is prepared to take additional measures to tackle deflation, this threat seems to have become less important.

Instead, potential headwinds may come from the European election cycle, including the European Parliamentary elections later this month, and the local and national elections in countries such as Belgium, Sweden Ukraine and the UK.

With Europe undergoing such a fragile recovery, any dramatic upset in the political arena could mean a step back for the region. Having already weathered the start of the Ukraine-Russia crisis, any further developments could see the returns of the past year start to decline. The next 12 months should be an interesting ride for European investors.