One year on from the Brexit vote and the UK stock market has reached record highs. The FTSE 100 has soared up to about 7,500, undeterred by an inconclusive election, waning consumer and business confidence, and a ticking leave clock. One fact you might have missed amid the furore: UK investors in European equities have done even better.
Over the past 12 months, just nine UK equity funds have made it into the top 100 in the IA UK and European equity sectors in terms of percentage returns. IA Europe Ex UK has returned just shy of 35 per cent; IA UK All Companies, just under 20 per cent.* The falling pound has helped European returns, but their percentage performance has been strong in euro terms too.
What is important now, though, is not so much the historic record, but who has the brighter outlook. For this, we must examine what is driving each market’s returns.
What is important now is not so much the historic record, but who has the brighter outlookSterling weakness
As we know, the pound has borne the brunt of Britain’s decision to quit the union – but at least we have had that mechanism. Weaker sterling has helped our largest companies, which earn much of their revenue overseas, to maintain share price and dividend growth.
If a lower pound is now fully priced in to our equities, where does the market turn for its next boost? Until a trade deal is reached, multinational conglomerates are holding off expansion on British shores. Banks such as HSBC and UBS are already moving jobs to the continent and car manufacturers are putting pressure on government time lines.
Lower down the cap scale, domestically focused businesses also face headwinds. Even without the benefit of a currency lift, small and mid caps have so far offered surprises to the upside. Despite the overall underperformance of UK equity funds versus European in the past year, two UK smaller companies funds made it into the top 10.
A more relevant question is whether our economy has gusto going forward. Falling consumer confidence and slowing wage growth suggest consumer spending might soon start to lag. An uncertain political and economic climate will do no favours to cyclical industries such as retailers and house builders and many consumer discretionary stocks.
Across the channel, the story is different. It has been a long time coming, but we can finally say Europe’s metrics are heading in the right direction. Inflation has been in positive territory across the eurozone (no mean feat given the extent of deflation in the wake of the sovereign debt crisis), employment stats are improving and rising GDP growth is forecast. At the latest European Central Bank meeting, economist Mario Draghi went so far as to hint that the nine-year rate-cutting cycle might be over.
In the March reporting season, a slew of companies posted earnings upgrades after several years of flat corporate profits at best.
Political views
In politics, anti-EU candidates were firmly rejected in French and Dutch elections. This has strengthened the EU’s mandate for unity at a time when the UK wants to leave. Keen to emphasise the benefits of membership – particularly to countries such as Germany and Italy whose elections are yet to come – Emmanuel Macron, Angela Merkel and their fellow European leaders are unlikely to make easy concessions on Britain’s access to the single market.
That said, Europe still has potential pitfalls of which investors need to be wary. A pertinent reminder came via the sale of Spain’s fourth largest bank, Banco Popular, to Santander earlier this month for €1 – yes, one euro. Shareholders waiting for a turnaround would have been sorely disappointed seeing the value of their investment plummet to zero in the final days of hasty selling before the announcement. Anyone buying a European index needs to be especially wary of picking up this kind of exposure.
Stock selection
Better, in my book, is to go with a fund that is notably selective about its stock and sector exposure. Henderson European Focus, with just 46 holdings as at end May, is a good example. Managers John Bennett and Asim Rahman analyse macroeconomic and industry themes as an integral part of their process, before applying individual stock criteria, which provides a double filter, if you like, for value and other traps.
Meanwhile, although Mr Draghi may be comfortable signalling the end of rate cuts, substantial quantitative easing is still in play and this has arguably inflated asset prices. European equities may be reasonably valued compared to their US and UK counterparts, but they are nonetheless trading only just below their Schiller PE 10-year average. So we are not looking at an extraordinarily cheap market and if the ECB does have to take its foot off the easing pedal more rapidly than expected, volatility could become an issue.
Another high quality concentrated option I like for this climate is BlackRock European Dynamic. Or, for smaller company exposure, Mirabaud Equities Europe Ex UK Small and Mid does a good job of finding the hidden gems.
For some UK exposure, Threadneedle UK Extended Alpha is an interesting option that lets you play both sides of the coin, as it takes both long and short positions in UK equities. Under the tenure of Chris Kinder since 2010, the fund has generated strong outperformance.
*FE Analytics, all funds in IA Europe Ex UK, IA Europe Inc UK, IA European Smaller Companies, IA UK Smaller Companies and IA UK All Companies sectors. Total returns in sterling. 23/06/2016 – 19/06/2017
Darius McDermott is managing director of Chelsea Financial Services
Key points
The FTSE has soared to 7,500.
European stocks have been overlooked, but are performing strongly.
It is best to go with a fund that is selective about stock and sector exposure.
