Fog shrouds Canary Wharf business district including global financial institutions Citigroup Inc., State Street Corp., Barclays Plc, HSBC Holdings Plc and commercial office building No.1 Canada Square on the Isle of Dogs on November 05, 2020 in London. England.
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According to Willem Sels, global CIO at HSBC Private Banking and Wealth Management, investors looking for value stocks should avoid allocating to Europe as the continent’s energy crisis means the risk/reward trade-off is still not there.
The macroeconomic outlook in Europe is bleak as supply disruptions and the impact of the Russian war in Ukraine on energy and food prices continue to dampen growth and force central banks to aggressively tighten monetary policy to curb inflation.
Typically, investors in search of value stocks – companies trading at a low price relative to their financial fundamentals – have turned to European markets as they seek to weather volatility by investing in stocks that are provide stable longer-term returns.
In contrast, the US offers a plethora of notable growth stocks — companies that are expected to grow earnings faster than the industry average.
Although Europe is a cheaper market than the US, Sels suggested that the difference between the two in terms of price-to-earnings ratios — companies’ valuations based on their current share price relative to their earnings per share — is not “compensated”. the extra risk you’re taking.”
“We think the emphasis should be on quality. If you’re looking for a stylistic direction and making the decision based on style, I think you should pay more attention to the quality differences between Europe and the US – growth versus value one,” Sels told CNBC last week.
“I don’t actually think clients and investors should be doing geographic allocation based on style – I think they should be doing it based on your economic and earnings prospects, so I would caution against going to Europe for cheaper valuations and interest rate movements.” to buy.”
With earnings season set to begin in earnest next month, analysts are broadly expecting earnings downgrades to dominate globally in the short-term. Central banks remain committed to raising interest rates to combat inflation, while acknowledging that doing so can lead to economic turmoil and potentially a recession.
“We are seeing an economic slowdown, prolonged inflationary pressures and higher public and private spending to address the near-term fallout and longer-term causes of the energy crisis,” said Nigel Bolton, Co-CIO at BlackRock Fundamental Equities.
However, in a fourth-quarter outlook report released on Wednesday, Bolton suggested that stock pickers might try to profit from valuation differences between companies and regions, but would need to identify companies that would help offer solutions to rising prices and interest rates.
For example, he argued that the case for buying bank stocks grew last quarter as hotter-than-expected inflation reports put further pressure on central banks to continue raising interest rates aggressively.
Beware of the “gas guzzlers”
Europe is scrambling to diversify its energy supply, having depended on Russian imports for 40% of its natural gas before the invasion of Ukraine and subsequent sanctions. That need was exacerbated earlier this month when Russia’s state-owned gas giant Gazprom halted gas flow to Europe via the Nord Stream 1 pipeline.
“The easiest way to mitigate the potential impact of gas shortages on portfolios is to be aware of those companies with high energy bills as a percentage of income – particularly where the energy is not from renewable sources,” Bolton said.
“The energy demand of the European chemical industry in 2019 was equivalent to 51 million tons of oil. More than a third of this electricity is provided by gas, while less than 1% comes from renewable sources.”
Some larger companies may be able to weather a period of gas shortages by hedging energy costs, which means paying below the daily “spot” price, Bolton pointed out. Also essential is the ability to pass rising costs on to consumers.
However, smaller companies without sophisticated hedging techniques or pricing power might struggle, he suggested.
“We need to be particularly cautious when companies that may appear attractive because they are ‘defensive’ – they have a history of generating cash despite slow economic growth – have significant unhedged exposure to gas prices,” Bolton said.
“A medium-sized brewer might expect alcohol sales to hold up during a recession, but unless energy costs are hedged, it’s difficult for investors to rely on near-term profits.”
BlackRock is focused on companies in Europe with globally diversified operations that protect them from the impact of the continent’s gas crisis, while Bolton said that of the continent-focused companies with greater access to Nordic energy supplies would do better.
If price hikes don’t dampen gas demand and rationing becomes necessary in 2023, Bolton suggested companies in “strategic industries” — renewable energy producers, military companies, healthcare and aerospace companies — could be allowed to run at full capacity.
“In our view, supply-side reform is needed to fight inflation. That means spending on renewable energy projects to address high energy costs,” Bolton said.
“It also means companies may need to spend to strengthen supply chains and deal with rising labor costs. Companies that help other companies keep costs down will benefit if inflation stays high for longer.”
BlackRock sees opportunities here in automation, which lowers labor costs, as well as in electrification and the transition to renewable energy. In particular, Bolton predicted rising demand for semiconductors and commodities like copper to keep up with the electric vehicle boom.
