A global recession has been incorrectly predicted many times. Still, “markets can act like this type of event is happening and sell off significantly,” says Stephen Lingard, senior vice-president and portfolio manager for Franklin Templeton Solutions in Toronto.
Lingard was affected by this phenomenon last year. He manages several Canadian-based multi-asset products and institutional accounts, and says he and his team were positive on European equities for 2016. However, global investors were spooked by geopolitical tensions, leading to weak returns despite solid European fundamentals.
Lingard’s experience shows how displaced market sentiment can affect predictions and portfolio decisions.
PREDICTION: 2016 would be a promising year for European equities.
Lingard and his team were optimistic about 2016, expecting results similar to the previous two years. “We saw year[s] like 2014 and 2015, which was global growth that was not too hot but not too cold. That was expected to lead to positive corporate growth in Europe, supported by central bank liquidity, low rates and fiscal policy. The U.S. had seen higher returns and so had Japan, while Europe [had been] delayed due to various political crises.”
In particular, says Lingard, “our view coming into the year was for a 12% local return for European stocks. Corporate profits for Europe were going to be in the sweet spot, which happens when European growth is 1.5% to 2%, which is what we expected for 2016.”
Based on that call, “we took down our overall weighting toward equities but, within that, we were overweight European equities for the start of the year.”
Of course, geopolitical risks were on the table, including the upcoming Brexit vote and the U.S. presidential election. But, says Lingard, “Europe was a favoured region.”
WAS THE PREDICTION CORRECT?
No. Says Lingard, “We expected 12% returns and we actually got 5% for the year, and that certainly underperformed our expectations.” Also, most of the growth came from the December rally in European equities.
One misstep, he explains, was that “we were very active in response to European events.” He and his team moved from an overweight in European equities to a more neutralized position right before Brexit—though they were still holding more than the market average. They then moved to an underweight by the end of the year, based on concerns that political volatility would persist.
“We could have potentially held on,” he adds, but a rally didn’t occur until December 2016, when European stocks were up about 8% in that month alone. At that time, “we went from negative returns to 5% for the year.”
Yet Europe’s growth and profit cycle for 2016 were both solid, which Lingard correctly forecasted. “We ended the year with decent growth as well as inflation that bottomed. This should have been a good year […] which was characterized by the December rally, but the [low] market multiple, during the year, we saw was unexpected.”
Lingard concedes, “there wasn’t a lot of great earnings growth last year, and market performance is driven by two things: corporate profits and the multiple that an investor will pay for those profits.”
For 2016, he adds, nervous investors were willing to pay 20 times earnings, on average, over the course of the year. But there was a low of 17.5 for the first quarter and a high of 22.5 at the end of September—even though European growth was stable the entire time (see chart below). That volatility weighed on returns and, ultimately, on the outcome of Lingard’s market call. (See chart below.)
Lingard hasn’t given up on European equities. Since the end of 2016, he says, “we have added back to Europe and are taking advantage of cheap valuations. But we’re doing this in a cautious way. We […] have upgraded European stocks to neutral,” based on the call for improved global growth and the fact that “Europe is a kind of pro-cyclical, higher-beta market.” He’s banking on the political risk premium for 2017, which provides an opportunity and longer-term upside.
Still, he’s prepared for another weak year. Lingard forecasts, once again, 1.5% to 2% European growth—based on the fact that there was 1.6% last year—as well as local returns of 10% to 12%. However, several elections are slated for this year in Europe, and if populism prevails, “People will question the continuity of the euro zone. The risk premium gets a lot bigger and [the region] could underperform.”
As an added hedge, says Lingard, “We’re protecting portfolios by owning cyclicality, as value has rebounded. We’re also holding more cash and gold, [but] aren’t overdoing defensive sectors. We’re not hiding in bonds or […] in stocks that have been beloved, like dividend stocks and interest rate-sensitive stocks.”