Viktor Nossek, Head of Investment & Product Analytics, Vanguard Europe
Many European investors have achieved diversification by investing in funds that track a broad universe - such as the MSCI Europe Index, which is comprised of the shares of large- and mid-sized companies from developed markets in Europe. While that strategy continues to serve investors well, there are a wealth of indices that can give more specific and targeted exposures within the European universe.
There are both similarities and differences in the way European countries have experienced the Covid-19 pandemic and their recoveries out of this unprecedented global event, while sharing common patterns, will also have aspects which are unique to each nation.
Something that stands out at the present time is the success of the UK’s vaccination programme and the implications this has for triggering a bounce back in the UK economy. Economic activity in the UK is fuelled by its service sector to a far greater degree than many other European economies, and this sector was impacted more severely by lockdowns and social distancing measures than many other areas of the economy.
With the UK’s rapid-roll out of its vaccination programme the service sector—which had been hamstrung by the virus—has begun to reopen. Further moves in this direction could continue to provide a tailwind for stocks reliant on domestically focused earnings. Those equities, we believe, may be best represented by the broader market mid-cap index, the FTSE 250.
Although the FTSE 100 is often seen as the barometer of the UK’s economic health, the benchmark is heavily skewed towards multinationals (FTSE 100 companies derive approximately three quarters of their revenues from overseas)1 and the prospects and drivers of those stocks tend to be more closely aligned to global trends. Meanwhile, a lesser proportion of the FTSE 250’s earnings are from overseas (less than 60%) 1 so the relationship with the domestic UK economy is much stronger.
One of the measures that suggests confidence is re-emerging in the real and expected recovery of European economies is dividend payments to shareholders. Many companies had suspended their dividends last year as they sought to shore up their balance sheets and strengthen, as much as possible, their loan/loss provisions. Across much of Europe, dividend payments that had been suspended amid Covid-19 restrictions have resumed and once again picked up the usual pattern of seasonality in their distribution.
The dividend windfall by European companies is typically paid out in the second quarter of the year (approximately 75% of annual dividends are paid out at this time)2 and after last year’s interruptions the outlook for European dividends has stabilised. As economies have begun to open up, investors have become more confident in the ability of European companies to distribute payments.
Past performance is not a reliable indicator of future results
Source: Factset. Data as at 30 April 2021. Dividends are in USD.
With the UK currently ahead of many European peers and the US in its vaccination effort, and given the generally greater agility of small-cap companies to bounce back from their relatively deeper retrenchments, they are positioned to outpace the growth of large caps. This should lead to better dividend growth as well.
Of course, the price at which any opportunity—in this case investment in the FTSE 250—is accessed is all-important. Looking at the price-to-earnings (P/E) ratio, FTSE 250 companies have already caught up with pre-pandemic levels and some investors may think the best opportunity to invest in this segment of the UK market has been missed. However, data suggests earnings should continue to recover.
The chart below indicates the worst is over following the 2020 earnings slump and that earnings (estimated) should recover in 2021 and 2022 to pre-Covid-19 levels.
Past performance is not a reliable indicator of future results
Source: Factset. Data from 5 June 2017 to 1 June 2021. Earnings per share in GBP. Any projections should be regarded as hypothetical in nature and do not reflect or guarantee future results.
The recovery in the P/E ratio and the premium by which it is trading relative to broader large-cap stocks in the UK is not just based on sentiment - it is justified by the fundamentals that underpin it.
Source: Factset as at 31 May 2021. Currency local.
Europe as a whole appears to be on the road to recovery out of the pandemic and investing broadly in European equities makes sense. At Vanguard, we believe a sound investment strategy starts with asset allocation. Studies show4 that for diversified portfolios, asset allocation decisions are responsible for the vast majority of a portfolio’s returns over time.
However, it is also worth understanding how different exposures can complement or detract from each other at different points in the economic and market cycle. A Europe ex-UK benchmark, giving value tilted large-cap exposure, could be complemented by an allocation to UK mid-caps that capture domestic UK growth through a FTSE 250 index exposure.
The UK’s lead in vaccination rollout, at the start of 2021, drove momentum in FTSE 250 stocks. Now that argument is moving on and the focus is shifting towards the consideration of valuations versus fundamentals. We believe that this could strategically position the role UK mid-caps could play in an investors’ portfolio beyond Covid-19.
1 Source: Factset. Data as at 31 May 2021. FTSE 100: 77% of earnings derived from overseas, 23% domestic. FTSE 250, 58% of earnings from overseas, 42% domestic.
2 Source: Factset. Data as at 30 April 2021
3 Source: Factset. Data as at 31 May 2021. Currency is local
4 Vanguard’s framework for constructing globally diversified portfolios, May 2021.
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