It’s difficult to say anything definite about Brexit without having to correct yourself shortly after. The only consolation is that decision-makers in both London and Brussels seem to be facing the same conundrum. However, let’s give it our best shot regardless. The likelihood of a hard, no-deal Brexit has lessened considerably in recent months, as reflected mainly in sterling’s gains so far this year (5.5% vs. the euro and 4.1% vs. the dollar as of 14 March 2019). In light of the 14 March vote and the current balance of power in Parliament, the UK is unlikely to exit the European Union on 29 March and may not do so until after European elections in late May. Several solutions will then be possible, but none will resolve all the questions that remain. We must keep in mind that, with the exception of a hard Brexit, all possibilities (such as the Norwegian model) are likely to have a similar impact on the economy and the markets.
Let’s not let the long divorce proceedings between the United Kingdom and the European Union overshadow developments in the global economy. Our overall economic scenario is generally quite optimistic, in particular for the United States, where the Fed’s shift in tone since the start of this year could open the door to a new phase of moderate but solid growth, driven by dovish monetary policy. Meanwhile, Sino-US trade talks appear to have taken a more constructive turn. Granted, nothing concrete has emerged from the talks as yet, but we remain confident that Chinese authorities will try to calm things down and do what is necessary to keep GDP growth between 6.0% and 6.5%. This should make the international environment a little more stable.
In Europe, we believe that the bad news on economic growth, which in recent weeks has led to downward 2019 growth revisions, is now behind us. For the eurozone specifically, the ECB’s March announcements do reflect some caution on the economic scenario, but at the same time ensure that dovish financial conditions will stay in place, with additional bank refinancing operations. With growth looking slightly below potential, acceleration in inflation in the eurozone is unlikely. The Fed, meanwhile, repeatedly sought to convince observers that it wanted inflation to surpass its 2% objective, in order to offset those years when, despite the economic expansion, it was well below 2%. This is a big change. Central banks are pessimistic on growth and hoping for a little inflation, which is not at all like the monetary policies that investors, ourselves included, expected for 2019. Rather than naming our 2019 Outlook “Regime Change”, perhaps we should have called it “Hotel California”, in reference to the Eagles song about a hotel that you can never leave and that symbolises addictions. Is quantitative easing (QE) in fact becoming a drug?
Only time will tell, but let’s keep in mind that while the Fed moved its key rates back to a neutral stance in late 2018, the ECB now, de facto, has very limited scope to react in the event of recession. Negative rates are bad news for banks; the ECB is well aware of this.
In the equity markets, valuation multiples have returned to normal and the main indices now look fairly priced (particularly on price/earnings), with the exception of Japanese equities, which are still undervalued. The variable to keep an eye on in 2019 is still earnings forecasts trends. After worsening, earnings per share (EPS) forecasts are now showing some encouraging signs of stabilising.
How our European large caps strategy reflects this environment
Assuming that the “markets” have something to tell us about Brexit, they don’t seem to be too worried, judging by how they have fared over the past two or more years compared to the immediate aftermath of the unexpected outcome of the June 2016 referendum.
First of all, UK shares (in sterling terms) have not underperformed the MSCI Europe ex-UK. Reactions to political developments over the past weeks, although difficult to follow, have mainly shown up in the pound, while the economy has so far stood up well to the many uncertainties. It is unlikely that all aspects have been priced in by the market, and we will have to continue to look closely at and think hard about these aspects.
The first step for our managers was to determine the international exposure of British companies in our Best Selection Europe portfolio. Unsurprisingly, these are mainly international companies, with the exception of British Telecom, which generates 83% of its revenues in the UK.
We then tested each stock in our portfolio to see whether it would react to a sudden drop in the pound or in equities. We found that our portfolios would not fare worse than their benchmark in these stressful situations.
Our simulation and portfolio analysis findings are reassuring but do not cover all possible scenarios. As mentioned in the introduction, politicians in charge of leading the negotiations seem to have little visibility on their outcome. Moreover, business surveys show that companies do not yet have post-Brexit solutions in place. Regardless of what happens between now and 29 March and thereafter, there is a lot of Brexit fallout to come.
Against this backdrop, our European ex-UK large cap strategy can address the genuine questions and concerns that investors are raising. Remember that this strategy was set up well before David Cameron had the idea of a referendum. We can now use this innovative and thorough investment process to offer a solution for coping with some of the Brexit uncertainties, while retaining access to an investment universe that is broader than just the eurozone in both the number of countries and companies it takes account of.
Source: FactSet, BNP Paribas Asset management, data as of February 2019
Keep in mind also that including UK stocks in our portfolio does not create any strong sector bias compared to its benchmark, the MSCI Europe.
An innovative approach; a conviction-based strategy
Our European large-cap management process includes an HHI-based analysis of sector concentration index (see callout box below). Sector consolidation has been shown to enhance companies’ profitability. Under our process, we select high-quality companies (i.e. with earnings growth consistently above average) that are expected to exploit their competitive edge.
We first look at the quality of the companies. Under this approach, we may reject a stock that would have been selected under a pure-growth approach, while identifying quality stocks that are not yet fully recognised as such by investors. We seek out “tomorrow’s winners” that will best exploit their sectors’ respective characteristics.
To better grasp the trends of an industry and its attractiveness, we use the Herfindahl-Hirschman Index (HHI), used by the US Department of Justice to ensure that a merger/acquisition will not skew competition by creating a dominant position. This approach gives us a useful grasp of market trends and the industries in which the companies we research operate. HHI is defined as the sum of the squares of market shares of each individual company within an industry. It can range from 100 (when lots of small caps share a highly fragmented market) to 10 000 (a monopoly situation). An industry is considered to be consolidated when its HHI is around 2 000.
Our research team calculates the HHI index for more than 800 industries using a sample size of more than 10 years. It does so on a global, regional or even national basis, depending on the relevance of the information provided. We also use our approach to monitor the possible sudden emergence of disruptive companies.
A sector is chosen on the basis of the HHI review. The analyst manager in charge of this sector then conducts exhaustive research into a stock. The investment committee consists of all the team’s managers – 10 professionals with average experience of more than 20 years, all of whom are both portfolio managers and analysts. The stock under review is submitted to the investment committee, which meets daily and decides on a collegial basis whether or not to select it. All investment proposals are subject to the committee’s approval. Successfully persuading our peers produces a conviction-based strategy for our clients. The decision whether to include the stock in the fund is also based on portfolio-construction and risk-management considerations. At this point, we are not trying to exploit a short-term market trend on any particular stock, but rather to take on long-term (three-to-five year) exposure. We do not turn over our (relatively concentrated) portfolio very often; remember that this process does not necessarily lead to selecting very large caps, but rather mid-caps in the large cap universe.
If any market event (such as new regulations, new management or a merger/acquisition) is likely to affect the performance of a chosen company, the investment’s relevance will once again be openly discussed by the committee. All of the committee’s decisions are thoroughly documented. This innovative management process has performed steadily under various market conditions, with an attractive relative risk/performance ratio and is recognised by consultants.
We also use an ESG (Environmental, Social & Governance) filter. Based on its findings, we may engage in a dialogue with companies that would otherwise perform poorly in these criteria, in governance in particular. When necessary, the fund managers provide ESG research and raise pertinent questions with the companies’ managers. Our management team has always been driven by this aspect of stock-picking, in particular in exercising voting rights at shareholder meetings. Feedback from our ESG analysts is now better structured within BNP Paribas Asset Management’s Sustainability Centre. The ESG analyst attends the committee’s daily meetings when their sector’s is under review.
 The aforementioned company is meant only as an illustration, not as a solicitation to buy its shares. This is not to be construed as investment advice or recommendations.