Tom Dorner and Stuart Brown: The case for European equity income
Tom Dorner and Stuart Brown, managers of the Aberdeen Standard Investments (ASI) Europe ex UK Equity Income Fund (OEIC), make the case for European Equity Income, assess what is driving the market and discuss the outlook for the sector and recent fund activity.
European equity markets continued their upward momentum rising 2.2% in July. This takes year-to-date return to ~16% and almost 70% from the lows in March 2020. This has been quite an extraordinary time for European markets and there have been some quite severe rotations underlying the strong performance at a market level.
Key drivers of European markets
Income: Income is driving long term equity total returns. Income portfolios need to be actively managed which is demonstrated by the fact that realised yields are often well below headline forecast yields;
Europe remains an attractive source of premium dividend yields. Yields on offer are a significant premium to other regions and other asset classes
Differentiated portfolio construction approach. ASI says that by capturing 3 different categories of income (High, Growth and Upgrade) investors can participate in equity upside whilst also providing downside protection, and overall offer attractive through cycle total returns.
Progress on COVID 19 in Europe remains positive. There remains some concern over the Delta-variant, which caused some weakness earlier in the month. However, the vaccine rollout has gathered pace and various countries have started to open their economies, for example, by removing travel restrictions.
While in the midst of Q2 earnings season it is noted that the operating performance of European corporates continues to be strong. So far 53% companies have beaten EPS with weighted EPS beating consensus by 21%, and this has sustained the positive earnings revisions that have been seen so far this year.
There is evidence of supply chain shortages and adverse impact of raw material costs in some industries. As a result there are some questions around margins going into H2 and it was notable that a number of shares performed poorly despite beating market expectations. The balance between re-opening tailwinds and supply chain issues will be a key area to watch in the coming months
The rotation in equity markets that ASI has referenced to several times since late 2020, in favour of Value stocks at the expense of Growth stocks, reversed sharply in June and July. Technology and Chemicals sectors performed strongly whilst there was a reversal in the performance of Oil & Gas and Travel & Leisure. The biggest driver of this was likely the continued decline in US 10 year bond yields which fell by ~20bps to 1.2% in July. Commodity prices remained broadly stable.
The Managers said it has been interesting to note the difference in the way the market has responded to results during the Q2 earnings season. European earnings have again been strong, but in a number of cases stocks have been weak despite printing strong results. One of the drivers of this has been concern over ongoing input cost pressures and supply shortages – both of which have been relatively well flagged for some time. Furthermore, there has been some slowing of growth in China from very high levels. From an income point of view, the outlook for dividends continues to improve with an increasing number of companies mentioning share buy backs in their communications.
The narrative surrounding inflation has also shifted quite notably with an increasing number of commentators expecting this to be transitory in nature. This has driven a quite sharp reversal in the performance of Value stocks in favour of Growth stocks. It is felt that the reopening of the economy in Europe in the coming months will provide opportunities in a number of industries, for example, in the Consumer sector. In support of this the managers confirmed the purchase of Adidas.
As ever we must bear in mind that it has taken unprecedented levels of stimulus to avoid a more severe crisis and at some point that will need to be paid for. Furthermore, longer term growth and interest rates likely to remain low at a time when debt levels continue to increase. In our view this means markets are likely to remain volatile over the medium term and navigating this requires an active approach to stock picking whilst maintaining portfolio balance.
We think Europe remains a perfect hunting ground for well-resourced bottom-up stock-pickers. It is a deep, liquid and complex market which allows us to seek out compelling and often mispriced investment opportunities that outflows from the region continue to miss out on.