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For today’s Soundbites, we’re talking about the opportunities and risks of investing in Europe. Our guest is Fergal Sarsfield, portfolio manager with Setanta Asset Management. We asked about consumer confidence in Europe, the likelihood of recession, and European-based companies that are a bright spot for investors. And we started by asking where we are in the inflation and monetary cycle in Europe.

Fergal Sarsfield (FS): I think the question is probably very tricky to answer. And that’s for the simple reason that no two economic cycles are the same. It’s very difficult to realize where we are, but if I go back to Q3 of last year, global central banks were uniformly putting forward the view that inflation was transitory. And we were somewhat skeptical about the transitory nature of inflation. The reason we felt that was that inflationary pressures were coming from multiple sources, and because of that, it would make it more difficult for central banks to get inflation under control. And then, I guess, fast forward to February the 20th of this year, and the terrible events which unfolded in the Ukraine, and that added another dimension into the mix, with the ongoing disruption to energy, tight supply chains, tight labour markets, as well as rising energy prices, and it just makes for a very, very difficult job for central banks. It could take quite some time to be resolved. And as it relates to markets, look, it’s not a pretty sight at the moment. Until such time as the market can see some line of sight in relation to interest rates and inflation, then I think market volatility will most certainly continue over the short-term.

Is Europe investable right now?

FS: There’s no doubt that markets are very much in a ‘risk-off’ mood at the moment. But yes, Europe is very much investable. We may have to suffer some short-term pain. But over the long term, there are great opportunities in European companies. And to be honest with you, they’re now beginning to trade at reasonable valuation multiples. It seems now more or less inevitable that Europe will enter recession over the coming months, but the most important question for us is whether it’s going to be a hard or a soft landing. What history has shown us is that in markets that are often driven by sentiment and momentum as much as they are driven by fundamentals, there can be dislocations between the intrinsic value of the company and what the market is willing to pay for it. So, the more dislocation you see, inevitably the closer we are up to the end of the cycle. When and if a new business cycle begins, I think there’s going to be wonderful opportunities in the European companies.

The implications of declining consumer confidence.

FS: Consumer confidence will be key in determining the duration of this interest rate cycle. Consumer balance sheets are relatively healthy, coming out of Covid. Consumers, they couldn’t spend during Covid. So, they’ve managed to save quite a lot on the back of that. They’re now having to put these savings to work, paying higher energy bills and other costs of living expenses. So, yeah, thus far, there hasn’t been any material drop in demand, and this is forcing central banks to act by passing through higher interest rates. And when consumer confidence falls to a level where it results in a drop off in demand, then I think we will see a better supply demand balance.

Names he likes.

FS: Diageo is an alcoholic beverage company that has very much benefited from premiumization over the last of the last number of years. Consumers are undoubtedly a lot more health conscious now, and that’s been a factor in moving away from high-calorie beer as well as trading up into top-shelf spirits. We expect that to continue for many years and they should very much be able to capitalize on growth in consumer spending. Adidas is another company we think that are very well positioned for the long-term. If you look at the sports and ath-leisure markets dominated by two brands: Nike and Adidas. They’ve got the heritage, scale of operations, financial strength that all helps ensure competitve threats are minimized. And that gives us confidence in the sustainability of the future earning space for Adidas. When it comes to revenue, Nike is by far the stronger. And, also, when you look at the percentage of revenues that have been generated from sales online. But that’s where we see the opportunity with Adidas as well. They should be able to migrate a good chunk of their revenues online, and with that comes better margins, as they catch up with Nike. Again, like Diageo, it’s a little tough for them at the moment. But we think that over the long term, that tailwind and a more health-conscious world will certainly benefit Adidas.

And, finally, what’s the bottom line on investing in Europe?

FS: Things may well look pretty bleak at the moment, but as a long-term investor, it may actually be a very, very good time to invest in Europe. Valuations are at levels below what we’ve historically seen. And they’re also at a significant discount to where the U.S. market is. On top of that, sentiment is very, very poor. It’s actually the largest underweight in history. So, investing in Europe has never been so much out of favour. So, if you believe that excess returns can be generated by going against the herd, by being contrarian, then this may well actually be prime time to invest in Europe.

Well, those are today’s Soundbites, brought you by Investment Executive and powered by Canada Life. Our thanks again to Fergal Sarsfield of Setanta Asset Management.

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