Dynamically emerging from the crisis
Both the American and the Asian economies swiftly returned to higher economic growth due to a more consistent handling of the pandemic. These countries are now acting as growth engines for export-oriented countries. Europe is experiencing a delayed, but therefore all the more dynamic, recovery from the crisis. The European equity market has the greatest catch-up potential among the developed economies. This is because European companies in particular will benefit considerably from an acceleration of the global economy. Inflation favours cyclical companies, which are often found in the European equity market.
Crises strengthen successful companies
Appetite for spending and consumption is returning. Stimulus packages will create additional demand in the future, which is why the upturn should be long-lasting. For us, the most relevant thing is that the crisis favours companies that were already successful. It only makes them better. Cost-cutting efforts of previous years have been intensified in the wake of the coronavirus pandemic, so that many companies are unusually lean and efficient. In the current phase of rising demand, higher sales meet a low-cost base, which strongly drives margins and profits.
Growth in many areas
In particular, the earnings growth momentum of European companies currently significantly exceeds that of US companies and we are not likely to see a reversal of this trend in the coming quarters. This development is also reflected in the expected free cash flow generation. On average, European companies have the highest free cash flow yields of all developed markets. Furthermore, European companies benefit overall from an attractive and higher dividend level compared to the other regions.
During the crisis, many companies benefited from government support measures, which not only ensured their survival, but also formed a good basis for their way out of the crisis. The tailwind from government fiscal policy measures should continue, with the US infrastructure programme and the European Recovery Fund, in particular, providing further impetus. The monetary policy of the central banks remains supportive. The structural low interest rate environment is entrenched for the foreseeable future.
We are seeing more inflation in the short to medium term. After inventories were reduced and investments were postponed during the crisis, many market participants and companies were not prepared for such a dynamic recovery in demand. Now it is primarily about delivery capacity - price is secondary. Transport capacities are limited and prices are exorbitantly high. Those companies that have pricing power are at a particular advantage here, as they can pass on higher costs to end customers. At the same time, costs for consumers will also rise in the coming years due to increasing regulation, such as the phased tariffs for carbon dioxide emissions. In this overall situation, the ramping up of industry goes hand in hand with rising inflation. This in turn favours cyclical companies, which are often found in the German and European equity markets.
If there is a persistently high level of inflation in the coming years, the central banks will have to react to it, even if the interest rate hikes are likely to appear homeopathic in a historical context. In the case of a persistent inflation level above the inflation target, we consider intervention by the central banks, as is currently being discussed in the US, to be realistic. In a historical context, cyclical equities have been an effective inflation hedge. This is another reason why we see many European companies as favourites compared to both those from other regions and defensive stocks, as they have such pricing power due to their export dependence and cyclical structure.
Since the end of March 2020, the European equity market has underperformed its American counterpart by around 25%. Valuations also show a significant discrepancy: US equities, for example, trade at a premium of almost 35% measured by the price/earnings ratio compared to European equities. Due to the high valuation divergences, we expect investors to focus more on European companies. In addition, compared to the European market, the US market is heavily influenced by technology companies, which could be exposed to more volatility due to upcoming regulations, US tax plans, and the beginning of the exit from the Federal Reserve's accommodative monetary policy (taper tantrum).
Potential in cyclicals
Overall, we see considerable potential for equities. Interest rates remain very low - despite rising inflation, as central banks and governments around the globe do not want to take any major financial market risks. The European equity market has the greatest catch-up potential among the developed economies. German companies in particular will benefit enormously from an acceleration of the global economy. While global equity markets are currently recording new all-time highs, there are still many individual stocks trading far below pre-crisis levels. Here we see the greatest opportunities in the less popular sectors such as banks, insurance companies or cyclical industry. Banks in particular have come through the crisis extremely well thanks to good capitalisation and sufficient risk provisioning. Dividend payments are not so much cancelled as postponed: with permission to pay out, the profitable and well-capitalised banks become interesting dividend shares again.
Authors: Olgerd Eicher, Portfolio Manager for the MainFirst Germany Fund and the MainFirst Top European Ideas Fund, and Thomas Meier, Portfolio Manager for the MainFirst Global Dividend Stars and the MainFirst Euro Value Stars
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