According to Willem Sels, global CIO at HSBC Private Banking and Wealth Management, investors should stay away from Europe if they are looking for value companies because the risk-reward ratio is still unfavourable due to the continent’s energy crisis.
As supply interruptions and the impact of Russia’s war in Ukraine on oil and food prices continue to impede GDP and push central banks to aggressively tighten monetary policy to contain inflation, the macroeconomic outlook in Europe remains gloomy.
When looking for value stocks—companies that sell at a low price relative to their financial fundamentals—investors typically look to European markets. Value stocks are businesses that generate reliable longer-term income.
In contrast, the United States has a wealth of well-known growth stocks, or businesses whose earnings are anticipated to increase faster than the sector average.
Sels argued that despite Europe being a less expensive market than the U.S., the difference between the two in price-to-earnings ratios, which measure how much a company is worth based on its current share price in relation to its earnings per share, does not “compensate for the additional risk that you’re taking.”
“We believe that quality should be prioritised. “I think you should look at the quality differential between Europe and the U.S., rather than the growth vs value one, if you’re looking for a style bias and are going to base your selection on style,” Sels said to CNBC last week.
“I actually don’t think that clients and investors should be looking at making the geographical allocation on the basis of style — I think they should be doing it on the basis of what is your economic and your earnings outlook, so I would caution against buying Europe because of the cheaper valuations and interest rate movements,” the author said.
Next month marks the beginning of the earnings season, and analysts anticipate that in the near future, profit downgrades will predominate globally. Even though they acknowledge that doing so could lead to economic unrest and even a recession, central banks are nonetheless committed to hiking interest rates to combat inflation.
Nigel Bolton, Co-CIO at BlackRock Fundamental Equities, stated that “we see an economic slowdown, higher-for-longer inflationary pressures, and greater public and private spending to address the short-term repercussions and long-term causes of the oil crisis.”
However, Bolton said that stock pickers can attempt to profit from valuation discrepancies between firms and geographies in a fourth-quarter outlook study released on Wednesday. However, stock pickers will need to find companies that will help supply solutions to rising costs and rates.
For instance, he claimed that during the past quarter, the rationale for purchasing bank equities has grown stronger as hotter-than-expected inflation readings have increased pressure on central banks to sustain aggressive interest rate increases.
Watch out for “gas guzzlers”
Europe is rushing to diversify its energy sources because, before the invasion of Ukraine and the ensuing sanctions, 40% of its natural gas came from imports from Russia. This requirement was made more urgent earlier this month when Russia’s state-owned gas company, Gazprom, stopped sending gas through the Nord Stream 1 pipeline to Europe.
The simplest method to reduce the potential impact of gas shortages on portfolios, according to Bolton, is to be aware of the businesses that have high energy costs as a percentage of revenue, particularly when the energy isn’t coming from renewable sources.
“In 2019, the energy requirements of the European chemical industry were 51 million tonnes of oil. Less than 1% of this power comes from renewable sources, whereas gas supplies more than one-third of it.
Bolton emphasised that some larger businesses may be able to weather a gas shortage by hedging their energy expenses, which means they pay less than the daily “spot” price. The ability to pass on increased expenses to customers is also crucial.
Smaller businesses, he said, would struggle if they lack sophisticated hedging strategies or pricing power.
Bolton added, “We have to be extra cautious when companies that might look alluring because they are ‘defensive’ – they have consistently made cash despite poor economic growth – have a high, unhedged exposure to gas prices.
“A medium-sized brewery may anticipate that alcohol sales will remain stable throughout a downturn, but if energy costs are unhedged then it’s difficult for investors to have faith in near-term earnings.”
Bolton said that of those centred on the continent, companies with greater access to Nordic energy supplies will perform better. BlackRock is focusing on European companies with globally diversified activities that insulate them from the impact of the continent’s gas issue.
In the event that price hikes fail to reduce gas demand and rationing is required in 2023, Bolton suggested that businesses in “strategically important industries” such as those engaged in the production of renewable energy, defence contracting, healthcare, and aerospace will be permitted to operate at full capacity.
“In our opinion, supply-side change is necessary to combat inflation. To solve the high cost of electricity, this entails investing in renewable energy projects, according to Bolton.
Additionally, strengthening supply chains and addressing rising labour costs may require organisations to spend money. If inflation continues to rise for a longer period of time, businesses that assist other businesses in cutting expenses stand to gain.
BlackRock sees potential in automation, which lowers labour costs, as well as those related to electrification and the transition to renewable energy sources. To keep up with the electric vehicle growth, Bolton specifically predicted increased demand for semiconductors and key minerals like copper.