By Tawhid Ali and Andrew Birse
European markets were turbulent due to the region’s proximity to the war in Ukraine and economic ties with Russia. Yet the performance of sectors and industries has varied in ways that may not be fully justified by changes in their fundamental outlook. A closer look can help guide investors through these uncertain times.
The MSCI Europe index fell 5.7% in local currency this year through March 18. In the UK, the MSCI UK index rose 2.7% over the same period, driven by heavyweight energy stocks. Both indexes rallied in the week ending March 18 to recoup nearly all of their losses since Russia invaded Ukraine on February 24. In January and February, European equities performed slightly better than US markets, which were hit by a sharp drop in their technology-intensive components. as interest rates resumed their rise; this trend reversed somewhat in March.
Sector performance was mixed (To display). Europe’s energy sector surged on rising oil and gas prices. Tech stocks were hit hard, mostly before the start of the war, amid a global sell-off in the sector. The health sector declined more modestly, while communication services increased slightly. In some sectors, industry performance also diverged. For example, pharmaceutical stocks were relatively resilient, while healthcare equipment and services stocks fell. Food retailers held up better than other consumer staples.
Sector and industry performance varied in a volatile quarter
Several market trends help explain recent market performance. We believe these trends can provide investors with some guidance for portfolios in a volatile environment.
Recession fears ahead
Concerns about macroeconomic growth are particularly acute in Europe. Given that the region is dependent on Russian oil and gas supplies, inflation risks stemming from a potential loss of a crucial supply are acute. Along with potential monetary policy missteps, Europe is particularly vulnerable to stagflation – a painful combination of an economic slowdown and high inflation.
European banks are in the eye of the storm. Banks suffer from stagflation but benefit from rising interest rates, which widen net interest margins – the difference between loan income and deposit payments. Recession fears and worries about exposure to Russia and other risky markets are weighing on sentiment. Yet investors should remember that not all banks are the same. Well-capitalized lenders with little exposure to Eastern Europe, relatively resilient loan portfolios and better balance sheets should be able to weather a downturn.
Automakers have also been hit hard. Automakers typically underperform during recessions as consumers cut back on big-ticket items. But before the war, expectations for auto sales volumes had already fallen to a nearly 30-year low of around 11 million a year. We think sales are unlikely to fall much further from here, even in a recession. In our view, shares of some automakers may have fallen more than they deserved due to overly negative expectations.
The industry also faced immediate war-related disruptions. For example, a severe shortage of wiring harnesses for cars, of which Ukraine is a major supplier, is causing production delays. However, since manufacturers can turn to cable harness suppliers in Eastern Europe and North Africa, we do not expect these disruptions to persist for more than a few weeks. Shares of European automakers and component suppliers are down more than 16%, implying a much longer disruption and deeper sales decline than we think.
Defensive sectors show resilience
Some defensive sectors performed better than the European market as a whole. The healthcare sector fell 1.0% in the year to March 18, but was actually up 6.9% since the start of the war. Within the sector, the pharmaceutical industry performed well. This is partly because drugmakers are allowed to continue selling products in Russia on humanitarian grounds, even under the sanctions that have driven many European companies out of the market.
The consumer staples sector underperformed. Still, some food producers have held up relatively well, as their businesses are unlikely to be undermined by a downturn. Utilities and real estate companies, which also tend to benefit from a rising rate environment, have fallen since the start of the year, but since the start of the war they have fallen only slightly. Selective positioning in defensive pockets of the market can help shield portfolios from some of the volatility.
Energy and defense companies benefit
Energy and defense companies have been the beneficiaries of the turmoil. Even as European energy companies have been forced to pull out of their Russian businesses, rising oil and gas prices are supporting stock prices amid already strong cash flows, much of which accrues to shareholders. However, the impact on raw materials is not uniform and some companies that depend on Russian and Ukrainian imports of steel and other raw materials are suffering disruptions.
Defense companies expect a huge boost in sales thanks to Europe’s renewed commitment to building up its capabilities. For example, Germany’s pledge to double its defense budget by €100 billion in 2022 will generate huge orders. Even as the defense momentum grows, we believe responsible investors must scrutinize companies to ensure they are not producing banned munitions that kill indiscriminately or selling products to bad actors.
Investors watching the tragic events in Ukraine might conclude that European stock markets should be avoided for now. We think that would be a mistake. While the war has indeed triggered extreme uncertainty and long-term change for investors, it is also likely to cause wide dispersions in sector, industry and company performance. By identifying companies whose businesses are resilient and less exposed to long-term threats, we believe that a portfolio of European equities can be positioned to help investors weather these difficult times.
The opinions expressed herein do not constitute research, investment advice or trading recommendations and do not necessarily represent the views of all of AB’s portfolio management teams and are subject to revision over time.
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Editor’s note: The summary bullet points for this article were chosen by the Seeking Alpha editors.