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Which European share sectors could offer the most value in 2018?

This European stock market outlook is taken from a series of..

This European stock market outlook is taken from a series of Schroders investment outlooks for 2018. Go to Insightsfor the full selection.

Our central view is that inflation will pick up over the medium term and therefore a value skew is likely to be appropriate for investors in European equities. By value, we mean those sectors that have been left behind in the current market rally in which investors have favoured growth above all else.

Autos, telecoms and banks are all examples of value sectors that we feel offer attractive opportunities in Europe. We have built our interpretation of the best portfolio to protect against our expectations of inflation.

Why is inflation coming back?

This view on the return of inflation is one that many people would disagree with, and indeed asset prices currently reflect expectations of future deflation.

But labour markets in Europe are tightening: latest data show the unemployment rate below 9% for the eurozone and a mere 3.6% for Germany. Capacity utilisation – a measure of how full factories are – has been rising and now stands at a high level of around 83%. Both of these factors are inflationary.

Will this pick-up in inflation become clear in 2018? Not necessarily. But by the time inflation shows up in the official data, it will be too late for investors to take advantage. The market and asset prices will have already moved to reflect that.

Applying common sense to topsy-turvy markets

When investing, the aim is not to try and time the change in market dynamic – that’s impossible without a crystal ball. Instead, we consider what is already priced in, apply a bit of common sense, and take a view on the best trade-off between risk and reward.

Many of the valuations within the European equity market today do not pass the common sense test. In this low inflation, low bond yield market investors have been forced to turn to reliable, low volatility, dividend-paying stocks such as consumer staples.

Due to strong demand, companies that offer these bond-type characteristics are sitting on extremely expensive-looking valuations.

However, the difficulty facing those companies is that their earnings growth is slowing. Investors have so far still been willing to pay up for the dividends and perceived stability, but when inflation returns, these factors will be less attractive.

Unlike many other income investors, we don’t simply buy high yielding stocks. Instead, we look at dividends in the context of the most upside we can find. The current high valuations of stocks like consumer staples mean they look vulnerable, in our view.

Huge disparities in asset prices

Consumer staples are not the only sector looking expensive. After this year’s rally, the valuation of the whole European equity market looks somewhat elevated relative to history. But hidden within this are huge disparities in prices.

Our preferred sectors – autos, telecoms and banks – are ones that have suffered in the low-rate environment of the past few years and now look very cheap.

The telecoms sector, for example, hit an all-time relative low recently. That’s a good starting point for a contrarian investor. In addition, the sector’s fundamentals are improving. After a period of intense competition between operators, we are now seeing market repair in many European countries.

Telecoms shareholders will soon start to reap the reward of years of building 4G networks and fibre to the home. We are currently at peak investment levels and so over the next few years the sector should start generating very strong cash flows.

Important to be pragmatic

The positioning outlined above is anti-consensual. But every debt crisis in the last 100 years has ended with inflation; aside from mass default and consequent depression, it’s the only way to cut long-term debt in an economy.

Ultimately we think inflation will take its toll on those investors who underestimated it, not those who overestimated.

As investors it is important we take a pragmatic view of the best opportunities available, in whatever part of the equity market. Not all of our holdings necessarily fit into the framework outlined here. We always make space for pure bottom-up ideas and continue to find reasonably priced investment opportunities on a three-year view.

More 2018 outlooks

Important Information: The views and opinions contained herein are those of James Sym, European Equities Fund Manager, and may not necessarily represent views expressed or reflected in other Schroders communications, strategies or funds. The sectors and securities shown above are for illustrative purposes only and are not to be considered a recommendation to buy or sell. This material is intended to be for information purposes only and is not intended as promotional material in any respect. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The material is not intended to provide and should not be relied on for accounting, legal or tax advice, or investment recommendations. Reliance should not be placed on the views and information in this document when taking individual investment and/or strategic decisions. Past performance is not a guide to future performance and may not be repeated. The value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested. All investments involve risks including the risk of possible loss of principal. Information herein is believed to be reliable but Schroders does not warrant its completeness or accuracy. Reliance should not be placed on the views and information in this document when taking individual investment and/or strategic decisions. The opinions in this document include some forecasted views. We believe we are basing our expectations and beliefs on reasonable assumptions within the bounds of what we currently know. However, there is no guarantee than any forecasts or opinions will be realised. These views and opinions may change. Issued by Schroder Investment Management Limited, 31 Gresham Street, London EC2V 7QA. Registration No. 1893220 England. Authorised and regulated by the Financial Conduct Authority.

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