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For today’s Soundbites, we discuss economic prospects in Europe. Our guest is Sean Kenzie, head of equities with Dublin-based Setanta Asset Management. We talk about the many threats to economic stability, and we started by asking if Europe is already in a period of stagflation.

Sean Kenzie (SK): In Europe, you have a dramatic squeeze on household budgets. For example, 40% of the U.K. population will spend 30% of their income on food and fuel. And after lodging, that doesn’t really leave a lot for discretionary spending. With European growth at 0.2%, and inflation now well above target at 7.5% and expected to rise further, it’s sort of the first time since the 1970s we had to really worry about stagflation. Then, of course, you have labour markets continuing to tighten. It certainly puts risk on this upward wage-price spiral, which central banks are very worried about. When central banks remove liquidity, that has a large bearing on multiples that investors are willing to pay for companies. So, at the moment, you have a risk of both multiples and earnings being hit at the same time, which is clearly bad for equity markets.

Threats to economic stability.

SK: Obviously the war in Ukraine has really brought into focus the E.U. reliance on Russian gas, which is about 40% of imports. And that is clearly a problem for Europe. And then, the sort of ongoing splintering and regionalization of supply chains, and the blurring of lines between economics and geopolitics. And then, the political instability in Europe is a bigger call-out. It seems to be a little bit more vulnerable to political risks with some protectionist elements. Now, that is always a backdrop in Europe, relative to the U.S. But I think taking a longer-term lens, if you look at demographics, Canada is expected to add 10 million people off a base of 38 million people by 2050. The U.S. will have 100 million more people by 2050. But the population of the E.U. 27 is expected to remain flat over the same time horizon. That is a structural headwind to European growth.

Companies he likes right now.

SK: One of the companies that we have looked at and invested in recently is a company called EssilorLuxottica [EssilorLuxottica SA, based in Charenton-le-Pont, France], and it’s the product of a 2018 merger between the Italian sunglasses and frame maker Luxottica, which owns Rayban and Oakley. It merged with the leading global lens maker which is Essilor. It then added on a number of opticians and a physical store network, called Sunglasses Hut. The combination of these elements gives you a one-of-a-kind in the industry. Then, of course, if you take a step back, the demand for corrective eyewear is structurally growing. Not only is there an aging population but people’s increased use of screens is leading to a step change in eye degradation. And Essilor is at the leading edge in the industry, and it should do quite well. You really want businesses that can protect their gross margins. CRH [CRH plc, based in Dublin, Ireland] is interesting in that regard. It’s an integrated solutions provider of building materials. As management say, they like to sell the road, not the rocks. Sixty-five per cent of their revenue is skewed towards this integrated solutions model. And that’s a huge contrast with peers. From an investment return standpoint, they pay a cash dividend yield at the moment of 3% and a buy-back yield of 4%. So that’s a return to shareholders of 7% per annum. They have a very clean balance sheet and they’ve got a lot of capital. Of course, longer term they should benefit from the U.S. infrastructure bill. So, it’s in a very interesting place.

And, finally, what should investors keep in mind as they ponder European investments.

SK: In this environment of tighter financial conditions and decelerating growth, it’s the companies with pricing power and operational leverage who are able to capitalize. Once you identify these factors, it’s just being really careful that you don’t overpay. If these companies with those attributes can translate these advantages into higher free cash flow conversion and rising dividend yields, and returns to shareholder, they should do well.

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

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