With European companies leading the structural shift to ESG investing and countries taking diverging paths out of lockdown, we feel the gap between winners and losers will be stark, giving long/short stock pickers the opportunity to generate meaningful levels of alpha.
We believe that the European Equity Long/Short proposition is more compelling than at any point in the last decade for a variety of reasons, both tactical and structural.
From a tactical perspective, differences in policies, vaccination levels and virus mutations among countries in Europe will mean huge disparities in economic recovery rates across the region. The ensuing variation in earnings revisions should offer many investment opportunities, both long and short. Given the magnitude of disruption caused by the pandemic, such variation in earnings is likely to be far more pronounced than it has been historically.
We have already been taking advantage of this phenomenon through significant long exposure to ‘reopening’ stocks in the UK, which is more advanced in its economic recovery than continental Europe due to a successful vaccination programme. However, we plan to shift some of this exposure as countries in Europe start to catch up, with analysts estimating that 70% of the region’s adult population could be vaccinated by early September.
In a wider global context, many major economies including China and the US are already in the midst of strong recoveries. Indeed, US GDP is now back to its pre-pandemic level, and it seems increasingly likely that much of the US macro data will have peaked by the end of Q2. In sharp contrast, European GDP remains 5.5% below its previous high. Given that the EU is lagging in its vaccination rollout, Europe is likely to have a more protracted economic recovery, which is yet to meaningfully accelerate. Consequently, while investors are already beginning to discuss the timing of monetary tightening in other major economies, the European Central Bank is likely to continue its Quantitative Easing efforts for an extended period of time, keeping liquidity at extreme levels. Fiscal policy is also becoming materially more supportive, with the EU recently announcing its largest ever stimulus package totaling €1.8 trillion to help rebuild a post-pandemic Europe.
European equity indices tend to be
weighted towards value and cyclical stocks. This partly explains why they had
consistently de-rated versus the more growth-oriented US market since 2015
until very recently. Even after a recovery in many value and cyclical names,
European equities still remain around one standard deviation ‘cheap’ versus
their US counterparts on a 12m forward P/E basis. While value and cyclical
stocks have consolidated their gains in recent weeks, we expect them to resume
their upward trajectories as inflation data moves higher into the summer due to
the strengthening global recovery, distorted year-on-year price comparisons and
supply chain disruptions pushing up producer prices.
Looking slightly further ahead, we expect there to be an increasing number of opportunities to profit from shorts over the next 6-12 months. The sharp market rebound that we have witnessed since April 2020 has seen a highly correlated upwards move in many sectors. However, as this market cycle matures, we expect to see far more divergence in stock returns, which should create a better environment for generating short alpha. We also believe that there is an increasing likelihood of market corrections in the order of 5-10%, given the strong rally that has taken place. Our robust risk management process is designed to protect the portfolio in these instances, as it has proven to do amid the extreme volatility over the last 18 months, and our short exposure is an integral part of this.
From a structural standpoint, the rich opportunity set that Europe offers for long/short investing due to disparities in operating performance is further enhanced by the region’s ever-changing political and regulatory backdrop. The most obvious example of this is Brexit, which catalysed years of sustained underperformance that ultimately left UK equities, particularly in the domestic mid-cap space, looking materially undervalued in our view. Elsewhere, the populist Eurosceptic parties are generally declining in popularity, with Italy recently electing as its new prime minister a quintessential establishment figure in the form of ex-ECB President Mario Draghi. As such, the country has moved rapidly from having arguably one of the least respectable governments in Europe to one of the most credible. Draghi’s appointment could have dramatic implications for Italian reforms over the coming months. With Germany heading to the polls in September and France soon after in April 2022, further political changes could be imminent, potentially sparking investment opportunities.
Such opportunities can also stem from regulatory changes. Europe has always offered a wide range of anomalous valuations gaps across sectors and countries. However, such structural inefficiencies are being exacerbated by onerous MiFID II regulations, which are resulting in sell-side brokers abandoning their research coverage, particularly in the small/mid-cap space, leading to more mispricing opportunities to take advantage of.
While European equities have seen over $150bn in net outflows since 2015, we believe that we are now at an inflection point where such fund flows will reverse. This is partly due to the reasons outlined above, but also because Europe is a genuine world leader in ESG, which continues to capture the global zeitgeist as investors increasingly demand profit with purpose. In aggregate, European equites have persistently higher ESG scores than the rest of the world. Perhaps more importantly from a long/short perspective, the drive for better ESG performance is likely to cause a wider dispersion of returns as a Principles for Responsible Investment study found that companies with higher ESG ratings outperformed their peers in a European equity portfolio. Similarly, whereas Europe previously lagged the US and Asia significantly in key structural growth areas such as technology, it is now home to a plethora of world-leading companies in the green/sustainability space, which we believe will be the defining structural growth opportunity of the next generation. Crucially, the €1 trillion ‘European Green Deal’ is likely to extend the EU’s lead over the coming years, specifically benefiting companies operating in areas such as renewables, renovation, green mobility and hydrogen.
As can be seen, Europe offers a rich hunting ground for long/short funds such as ours that are opportunistic, style agnostic and focus on fundamentals. We aim to generate steady, relatively low volatility returns that average 1% net of fees per month, whilst preserving our clients’ capital in adverse market conditions. We welcome the opportunity to add value for our clients going forward.
Nothing in this document constitutes or should be treated as investment advice or an offer to buy or sell any security or other investment. TT is authorised and regulated in the United Kingdom by the Financial Conduct Authority (FCA).