Fears that global trade tensions will worsen have seriously depressed investor sentiment in Europe. Although there has been no economic shock or any further deterioration in macroeconomic indicators – PMI and IFO indexes have stabilised and are signalling a continuation of economic growth – since September investors have rotated out of growth stocks and into value and defensive stocks on concerns about the impact of rising interest rates globally.
That sector rotation has enabled large caps to make up lost ground relative to European small and mid-caps, which had outperformed blue chips between the start of 2018 and the end of August. As a result, at the end of September, the MSCI Europe index was showing a year-to-date gain of 0.84%, similar to the 0.75% increase in the MSCI Europe Small Cap index. The heavy rotation and market declines have continued in October, with the MSCI Europe Small Cap index declining by 10.64% against a 7.73% drop for the MSCI Europe index (month to date as at 26 October 2018).
Investor risk-aversion remains very high in the European markets – resulting in a “risk-off” rather than a “risk-on” attitude – and worries about the difficult Brexit negotiations and the stand-off between Rome and the European Commission regarding the Italian budget mean that the climate of uncertainty will continue in the coming weeks and months. However, we believe that investors’ loss of confidence is probably overdone on a short-term view. Given the indiscriminate nature of the recent sell-off, it is reasonable to think that the market offers some interesting buying opportunities, provided that the various economic sentiment indicators do not show a further decline in confidence in Europe.
European small and mid-caps: P/E ratio of less than 14
Small and mid-cap stocks are more exposed to the European economy, and this higher domesticity provides some insulation from concerns about the impact of tariffs and trade wars. Their underlying fundamentals remain attractive, with earnings expected to grow by more than 10% in the next 12 months.
They are also less expensive than at the start of the year – the average forward P/E ratio of European small and mid-caps is now less than 14 versus 17 at the start of 2018 – and so offer genuine investment opportunities. Provided that stocks are selected carefully, using a “bottom-up” method, we currently see a number of opportunities in small and mid-caps in France, Ireland and Spain. We also retain our focus on companies positioned in niche markets, with good pricing power, an international outlook and solid balance sheets.
Charlie Anniss
European Small and Mid-Cap Portfolio Manager