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The European equity market has gained 16.5 percent year-to-date, making this asset class one of the best performers this year. The performance comes at the back of an ECB Quantitative Easing (QE) policy, subsequent currency adjustments, a favorable commodity price environment and hints of a European economic recovery.
The lack of any significant news from Ukraine and consistent postponement of any action on Greece added to the already fertile ground for optimistic expectations on European equities.
Investors holding these gains cannot be faulted for being concerned and investors may be weary of investing at current prices. As an investment manager responsible for an equity fund I tend to be swimming in the same waters. The following are my expectations and the strategies that may be applicable for this environment.
First things first, it is paramount that investors have a diversified portfolio in-line with their investment risk profile. If you do not know what I am referring to, look for another financial advisor.
Also, when I refer to European equities I normally refer to large cap European equities. They are the investments I follow and have built knowledge on. This is based on the belief that cautious investment in large-cap equities will provide the best long-term return. In addition, and probably as important, information on these companies is readily available.
ECB Quantitative Easing
QE will continue to support markets for the next year and a half. It is unthinkable that equity markets go through a bear market during a QE program. However, the significant gains observed at the start of the program are unlikely to be repeated. Rather, QE will provide the necessary stimulus to support a constant recovery path.
Exchange rate
Most of the adjustment has taken place already and for good reason the ECB is not comfortable with further Euro declines. One has to keep in mind that European powerhouse Germany is probably firing on all twelve cylinders of its metaphorical V12 economic engine.
The weaker Euro intended to support inefficient peripheral countries will push Germany beyond its production limits impacting its long-term efficiency. I believe that the target floor set by the ECB is close to current levels. The ECB will react, verbally or otherwise to a Euro approaching parity with the US dollar.
The rest of Europe is probably relieved that the Euro is weaker. Economic growth especially in the European peripheral countries is already showing sign of recovery.
Commodity prices
Commodity prices are having a positive effect on European manufacturers… up to a point. While undeniably lower oil and metal prices have a positive impact on European economics, the full impact is somewhat mitigated. Companies were surprised by the massive decline in commodity prices and are still stuck on the wrong side of hedging instruments. Going forward this effect will decline gradually increasing the impact of declining input costs
The weaker euro also reduces some of the positive effects from the decline in commodity prices. Although I believe that it is not good practice to hedge commodity exposures without hedging your currency risks.
Outliers
A Greek default and a restart of the conflict in Ukraine are two events that may disrupt the market environment. Unfortunately both events appear plausible in the short-term. Long-term investors invariably experience similar geo-political events from time to time. History has shown that these events present investing opportunities as uncertainty effects even the safest assets. However, this is a personal choice that depends on one’s risk profile.
Expectations & Strategy
In this environment I expect equity prices to hover around current levels for some time. Mid-year corporate earnings will show that large caps are doing well, but share prices may remain sticky as they have advanced too rapidly to date. A strong positive trend may develop in the third quarter as signs of a European recovery persist.
As it is difficult to time market bottoms and peaks, it is preferable to hold shares in European large caps through volatile periods. Being well positioned when equity market rally is key, and that can only be achieved by investing when markets are weak. Geopolitical events add uncertainty to the scenario.
For the next three months I will be holding on with dear life to my winners. These would be the shares that have performed well year-to-date. Typically they are well led companies selling standard setting products and services. They will continue to be the core of my investments. And I am confident that they will recover should an exceptionally disruptive event occur.
I will take the opportunity to sell any losers. Shares that under optimum market conditions performed badly. These are companies that have underperformed maybe because of unfavorable market conditions, but mainly because of failing to adapt to market trends or change in consumer preferences. Whatever the reason, if year-to-date you are losing money on a share, you should have a hard look at it.
Never hold on to an investment because you hope that you will get your money back; hope is a very poor forecasting tool. I will also add cautiously as markets develop, using any ‘off days’ buying opportunities. The target is to be at an ideal allocation towards mid-August latest.
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