Brexit dice No Deal, Deal

Europe continues to be tested by uncertainty over Brexit, political turmoil in Italy and other countries, and fallout from the U.S./China trade dispute. However, the region is maintaining positive economic growth and reasonably healthy stock markets.

Resilient domestic demand is helping to counteract the effects of slowing global trade. Strong labour markets are the bright light shining on the eurozone; the unemployment rate is hovering around 7.5%, the lowest level since mid-2008.

While wage growth was slow for several years following the global financial crisis, it is picking up momentum. The services sector in Europe, powered by healthy demand, is holding up well and providing a boost to the region.

However, manufacturing and industrial production are weaker components of the economy, with activity decreasing in Italy and Germany due to slower growth in China and other export markets. According to the World Bank, global economic growth is expected to drop to 2.6% this year from 4.1% year-over-year, and the fall-off in trade has affected mainly capital goods so far.

The European Central Bank (ECB) lowered its 2019 GDP growth forecast for the eurozone to 1.1% from the previous forecast of 1.2%.

Monetary and fiscal policies have turned stimulative, and the ECB cut the deposit facility rate by 10 basis points in September. In addition, although the ECB withdrew its quantitative easing bond-buying program late last year, the central bank decided to reinstate the program in an attempt to boost economic growth: the ECB will buy US$22 billion worth of bonds a month, beginning in November.

Exports to emerging markets account for almost 10% of the eurozone’s GDP, which means further escalation of trade conflicts and any stumble by China are risks to European exporting industries such as automobiles. Europe would get a boost from any resolution in trade issues, although political progress between China and the U.S. has not followed a linear path. Europe also stands to benefit from any significant stimulus by China to its economy.

Price momentum in European equities has been more sluggish year-to-date than in the U.S. market, which presents some compelling valuation opportunities in specific stocks, according to portfolio managers of European equity mutual funds. In Europe’s stock markets, as in North American markets, as bond yields drop, there have been stronger flows into economically defensive stocks than into cyclicals and, therefore, interest rate-sensitive stocks are relatively more expensive.

Dominic Wallington, senior portfolio manager, head of European equities and portfolio co-manager of RBC European Equity Fund (along with David Lambert, senior portfolio manager) with London-based RBC Global Asset Management (U.K.) Ltd., gives priority to companies with an international business focus that can benefit from global growth and emerging market demand. By looking beyond domestic economies in Europe, he is able to achieve stronger business diversification and offset short-term volatility in business cycles.

For example, although about 47% of the RBC fund’s holdings have headquarters in the U.K., the companies’ businesses are not confined to that region.

A top holding in the RBC fund is Unilever PLC, which has co-headquarters in London and the Netherlands but derives a growing proportion of earnings from emerging markets.

Unilever’s products include food and beverages, cleaning agents, beauty products and personal-care products. Top brands include Dove, Knorr, Lipton, Hellman’s and Ben & Jerry’s. While Unilever benefits from growing sales in emerging markets, it meets U.K. and Netherlands’ standards for accounting and corporate governance.

“Our exposure is to large, international companies – and Brexit hasn’t hurt them at all,” Wallington says. “In fact, many companies have benefited from weakness in [the pound] sterling. We look for high-quality companies with low capital requirements.”

Wallington, a self-described “professional worry wart,” keeps an eye open for risks. Political outcomes in various countries are “opaque,” he says, so making investment decisions based on these issues is difficult.

However, a more important factor is technological change and its potential for disruption.

“We focus on companies that have coped well with disruption in the past,” Wallington says, “and many of these are stable firms that have been around for a long time. Rather than [being]nascent opportunities, the vast majority of companies in the portfolio have already succeeded in building success.”

The RBC fund’s biggest sector allocations are in consumer staples (19%), financials (18%) and health care (17%). Wallington is particularly attracted to companies that have built powerful, lasting brand recognition. Brands with longevity have been able to innovate, differentiate themselves from competitors and expand distribution.

Another key holding in the RBC fund is LVMH Moët Hennessy-Louis Vuitton SE, a Paris-based company that produces luxury goods, including wine, cognac, perfumes, cosmetics, luggage and jewelry. Brands include Moët champagne, Hennessy brandy and Christian Dior fashions.

“The company’s history dates back to the mid-19th century,” Wallington says. “It’s known for innovation, and has never lost its cachet. [The] brands benefit from rising demand from the growing middle class in China.”

On the health-care side, Wallington likes Novo Nordisk A/S, a Denmark-based multinational pharmaceutical firm that has been at the forefront of medications for diabetes. Diabetes is “unfortunately becoming a global pandemic,” Wallington says.

In the financial services indus- try, the RBC fund is underweighted in banks and concentrated in businesses that are better capitalized. For example, the fund holds London Stock Exchange Group PLC and Schroders PLC, a U.K.-based asset-management firm.

Ben Zhan, vice president and portfolio manager with Toronto-based 1832 Asset Management LP and lead portfolio manager of Dynamic European Equity fund, says that while media headlines focus on sluggish economies and other problems in Europe, there is more financial stability in countries such as Greece and Spain than in recent years. Furthermore, Europe’s banking system is stronger and better capitalized since the 2008 financial crisis.

“People pay too much attention to headline news,” Zhan says. “We don’t buy the economy; we buy strong companies that are riding secular trends. There are a lot of European companies that have grown and prospered despite the ups and downs of the past 10 years. [Europe] is a great market for active stock-pickers.”

Zhan has identified three trends that create opportunities: technology, consumerism and the growing power of China.

“Technology is changing people’s lives, and Europe is home to some of the best [tech] companies in the world,” Zhan says.

Among the Dynamic fund’s key tech holdings are SAP SE, a Germany-based multinational software firm specializing in business applications, and ASML Holding NV, a Netherlands-based chip maker and the world’s largest supplier to the semiconductor industry. Zhan also likes Infineon Technologies AG, a Germany-based global leader in semiconductors with expertise in electric cars’ power management.

On the consumer side, there is strong appetite for superior products related to appearance, health and entertainment, Zhan says, and Europe is home to long-established brands. Holdings include France-based Pernod Ricard SA, a premium alcoholic beverage maker, and LVMH.

The rise of China is fuelling demand for luxury goods, Zhan says, and there is a long history of trade between Europe and Asia.

“It is beyond question that China is on its way to being an economic superpower,” Zhan says. “Europe is benefiting from the growth of Chinese consumption and tourism. The desire for prestigious brands has only touched a small portion of China’s society, and the real demand lies ahead.”

The Dynamic fund has a concentrated portfolio of 44 stocks, and Zhan focuses on large, high-quality companies with the financial means and dexterity to survive difficult economic times.

For example, a top holding in the Dynamic fund is Mowi ASA, a Norway-based seafood company and global leader in salmon farming. Salmon can be produced more efficiently than beef and is a viable source of protein, Zhan says, particularly in countries such as China, where diets are improving with income.

There are many unknowns surrounding Brexit, Zhan says, but the U.K.’s global impact is relatively minor, given the region’s US$2.8-trillion economy. With China’s economy growing by roughly US$1.5 trillion a year, he says, two years’ worth of growth in China can exceed the entire annual economic production of the U.K.

Zhan expects certain U.K.-based companies to do well no matter how Brexit unfolds, including Burberry Group PLC, a luxury fashion company, and Diageo PLC, a giant producer of beer and spirits.