European Investors Return From Beach to ‘Extremely Edgy’ Market

(Bloomberg) -- For European investors just returning to their offices with a tan and tales of packed beaches and heat waves, there’s plenty to catch up on: Brexit, U.S.-China trade, Italy, Hong Kong and the ECB.

It’s been an unusually turbulent summer, to say the least. The VStoxx gauge of euro-area volatility this month reached its highest since early January. The cost of betting against the region’s equity benchmark with options jumped to the most versus bullish wagers in more than a year, indicating increasingly bearish positioning.

For European investors, the quest in September will be to find a holy grail of stocks not too exposed to market gyrations but are also reasonably priced.

The descent was swift at the start of the month for European equities that were near one-year highs as recently as July. But for stock pickers returning to a whipsawed market, it’s like summer never happened. The same trades that have paid off overall in 2019 -- stocks relatively insulated from the economic cycle -- are still doing so. They have become pricier on a relative basis, but with recessionary risks only growing, there seems little appetite to rotate into cheaper, cyclical shares.

“The worry wall is quite wide -- there is quite a lot to pin on it at the moment,” said Philip Webster, director of European equities at BMO Global Asset Management. “As long as there is growth, people will just pay up for that irrespective of what the valuations look like at the moment. However long you’ve been there, the more you’ve paid, the more you’ve made.”

Of course, sectors deemed less sensitive to economic swings have been in vogue worldwide. But in Europe, their outperformance is starker, with defensive stocks trading at the highest versus cyclicals since 2016.

Just skim the August headlines: Germany is on the brink of a recession. A no-deal Brexit is increasingly plausible. Unrest in Hong Kong is disrupting business for Europe’s luxury houses. And worryingly for traders betting on more European Central Bank stimulus, the hawks are getting louder.

These are hard to miss even from the beach. And then there are the U.S.-China trade tensions, from which there is no escape. Europe might not be a direct party to the feud between the world’s two biggest economies, but its high dependence on exports means the stocks are even more sensitive to President Donald Trump’s tweet storms.

No wonder then that in the exchange-traded funds market, defensive sectors have been all the rage. And staying safe has also paid off for money managers. Exposures to such industries have helped 59% of European mutual funds beat their benchmark in August, the highest percentage this year, according to Barclays Plc.

“The extreme polarization in market internals is another sign of significant risk-aversion from investors, in our view, and suggests that equities are not all priced for perfection,” Barclays strategists led by Emmanuel Cau wrote in a note.

Barring contrarians, the challenge for European investors in September is to channel their inner Goldilocks: find stocks whose valuations are not too hot, and profit forecasts not too cold.

For instance, Financiere de L’Echiquier SA’s growth fund owns Prysmian SA and Michelin. Both might seem cyclical, but according to portfolio manager Matthieu Detroyat, the former is a “self-help story” aided by its U.S. subsidiary General Cable, while the latter gets steady business from tire replacement. The fund has gained 27% this year, beating 98% of its peers, data from Bloomberg show.

“The market is looking for quality, visibility and growth,” he said from Paris, adding that it might be too early to pile into cyclicals, despite their attractive valuations.

Over at BMO Asset, Webster is trying to strike a balance between risk and price. Case in point: he holds RELX Plc, an information-services provider trading at 20 times the coming year’s earnings, in addition to Ryanair Holdings Plc, the beleaguered airline priced at nearly half of that.

“The market is extremely edgy,” he said. “There are opportunities there, but you need to sit somewhere uncomfortable.”

To contact the reporter on this story: Justina Lee in London at jlee1489@bloomberg.net

To contact the editors responsible for this story: Blaise Robinson at brobinson58@bloomberg.net, Namitha Jagadeesh, Celeste Perri

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