Europe revisited

A bit like the unpredictable weather we’ve had over the past few weeks, politics has been a rollercoaster. As expected, the UK election delivered a Labour win. While there might be tax and broader fiscal implications at the individual level, the outcome wasn’t unexpected, which is why it hasn’t moved markets that much. At this stage, we’re neutral UK equities and, in our sterling portfolios, we’re increasing our gilt exposure. Conversely, the French election created a risk of a right- or left-wing absolute majority implementing unorthodox policies, including significant fiscal spending (though not likely going as far as arguing for exiting the euro), which could have impacted European and French market sentiment – as we saw over the past few weeks. This risk hasn’t materialised, presenting a buying opportunity for European stocks and bonds.?

One lesson for investors trying to position for political outcomes is: don’t. They’re very hard to predict, and it’s even harder to predict how the market would react. The investments we make are driven by a thorough research of the ‘fundamentals’ (such as valuation) and ‘technicals’ (such as momentum) of an asset class. Furthermore, we make these decisions in the context of our globally diversified portfolio, which we believe minimises the impact of local events, including (geo)politics. A wobble in one part of the portfolio can be offset by a gain somewhere else. Of course, this doesn’t mean that one shouldn’t look at election outcomes. I and the Investment Committee were already preparing to increase our exposure to European equities, as we considered (and still do) the fundamental case to be compelling. We paused that idea ahead of the French election, mindful of the risks. With that risk now passed, we decided to go ahead.

Increasing exposure to European equities

In our Mid-Year Outlook we argued that we shouldn’t rip everything up and start again with a new view just because it’s the middle of the year. Instead, we are adapting to today’s markets and attempting to anticipate what may come next. Give or take, we think our baseline scenario of a US ‘soft landing’ (slower but positive growth), a gentle acceleration in the eurozone/UK and some stabilisation in China is playing out.?

Inflation in the eurozone has been steadily decreasing since its peak in October 2022. Now, it’s nearing the European Central Bank’s (ECB) 2% target and, last month, the central bank cut rates for the first time in five years, joining the Swiss National Bank and Sweden’s Riksbank. We think the ECB is likely to cut again in September. We believe this removes (at least partly) a major headwind for economic growth and equities. In the absence of a recession, history shows that interest rate cuts could boost equities. So, given our view that there’s a higher probability of a recovery than a recession in Europe, adding to European equities is a logical next step. Higher interest rates have also weighed on consumption and investment, so lowering rates is likely to alleviate these concerns. We expect one or two more rate cuts from the ECB this year, which could further benefit European equities.

While there could be long-term effects, we doubt that the elections in Europe will have a material impact on European equities, taking a 6–12-month view. A hung parliament in France limits the room for unorthodox policies, as the need to form coalitions also means seeking compromises. In Italy, where a right-wing coalition has been in charge since October 2022, the fact that the less mainstream views on euro membership have been abandoned mitigated any market reaction, with Italian equities performing in line with, or better than, their peer group.

Taking profits on global small-cap equities

While the European equity investment means that we’re now overweight European equities (we own more compared to our long-term strategic asset allocation), we want to keep our broad equity exposure the same. Therefore, we need to fund this purchase by selling some equities. With the outlook changing in the US (positive but slowing growth, fewer and later rate cuts) and Europe (positive and accelerating growth, more and earlier rate cuts), we’ve decided to lock in the profits on our global small-cap position vs bonds and use these to fund our European equity investment.?

This means that, while valuations are attractive, we no longer think small caps will outperform large caps in the near term. Rather, we think large caps will lead the way, which is why we position our flagship portfolios with mostly large-cap companies. We do this both via the investment funds we select from across the industry, in line with the ‘open architecture’ principle of our investment philosophy, and through our single-line stock portfolio, which includes both European and US companies (which, across funds and single lines, represent the bulk of our equity exposure).

Adding more European bonds, reducing US Treasuries

In fixed income, we’re keeping our overweight exposure to EUR investment-grade (IG) bonds. This is partly because we like the yield these bonds offer, but also because the ECB cutting rates in an improving economy could be supportive. But, for quite some time, we’ve been underweight European government bonds. It wasn’t clear when the ECB was going to cut interest rates and, if one really wanted to increase fixed-income exposure, EUR IG bonds offered more compelling yields.?

While we’re keeping our overweight EUR IG bonds position, we’re now entering an overweight position on short-dated European government bonds, too. This is because short-dated bonds are most sensitive to central bank rate changes. So, with the ECB now cutting rates, one-to-three-year European government bonds could benefit, as prices rise when yields fall. With the Fed not cutting rates yet and perhaps underdelivering compared to market expectations of a couple of cuts this year, we’re financing the short-dated European government bond purchase by selling some of our US Treasuries.

Protecting portfolios against volatility

There are still lingering (geo)political risks, not least from any volatility associated with the US election in November. Earlier this year we bought an ‘insurance’ instrument (technically a warrant) in our flagship portfolios and those where client knowledge and experience, and regulations, permit. This was to partially protect portfolios from such volatility. This is an instrument that appreciates in value if there is an equity drawdown, protecting portfolios, for the part ‘insured’, against unexpected events.?

Our European insurance instrument has worked well, cushioning the downside in the recent periods of volatility. But, following the rise in US equity markets this year, our US insurance instrument would only cushion the downside after a significant fall. Therefore, we’ve decided to sell our current US ‘insurance’ position and buy it again at today’s levels (known as ‘restriking’). This means the protection would kick in earlier if a drawdown were to occur.