HSBC warns investors to avoid European stocks

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Fog shrouds the Canary Wharf business district including global financial institutions Citigroup Inc., State Street Corp., Barclays Plc, HSBC Holdings Plc and the commercial office block No. 1 Canada Square, on the Isle of Dogs on November 05, 2020 in London, England.

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Investors should avoid allocating to Europe in the hunt for value stocks, as the continent’s energy crisis means the risk-reward is still not there, according to Willem Sels, global CIO at HSBC Private Banking and Wealth Management.

The macroeconomic outlook in Europe is bleak as supply disruptions and the impact of Russia’s war in Ukraine on energy and food prices continue to stifle growth, and force central banks to tighten monetary policy aggressively to rein in inflation.

Typically, investors have turned to European markets in search of value stocks — companies that trade at a low price relative to their financial fundamentals — when trying to weather volatility by investing in stocks offering stable longer-term income.

By contrast, the U.S. offers an abundance of big name growth stocks — companies expected to grow earnings at a faster rate than the industry average.

Although Europe is a cheaper market than the U.S., Sels suggested that the differential between the two in terms of price-to-earnings ratios — companies’ valuations based on their current share price relative to their per-share earnings — does not “compensate for the additional risk that you’re taking.”

“We think that the emphasis should be on quality. If you’re looking for a style bias and are going to make the decision on the basis of style, I think you should look at the quality differential between Europe and the U.S., rather than the growth versus value one,” Sels told CNBC last week.

“I actually don’t think that clients and investors should be looking at making the geographical allocation on the basis of style — I think they should be doing it on the basis of what is your economic and your earnings outlook, so I would caution against buying Europe because of the cheaper valuations and interest rate movements.”

With earnings season set to kick off in earnest next month, analysts broadly expect earnings downgrades to dominate worldwide in the short term. Central banks remain committed to raising interest rates to tackle inflation while acknowledging that this may induce economic strife, and possibly recession.

“We see an economic slowdown, higher-for-longer inflationary pressures, and greater public and private spending to address the short-term consequences and long-term causes of the energy crisis,” said Nigel Bolton, Co-CIO at BlackRock Fundamental Equities.

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However, in a fourth-quarter outlook report published Wednesday, Bolton suggested that stock pickers can seek to capitalize on valuation divergences across companies and regions, but will have to identify businesses that will help provide solutions to rising prices and rates.

He argued, for example, that the case for buying bank stocks has strengthened over the last quarter, as hotter-than-expected inflation reports have exerted further pressure on central banks to continue raising interest rates aggressively.

Beware the ‘gas guzzlers’

Europe is racing to diversify its energy supply, having relied on Russian imports for 40% of its natural gas prior to the invasion of Ukraine and subsequent sanctions. This need was exacerbated early this month when Russia’s state-owned gas giant Gazprom cut off gas flows to Europe via the Nord Stream 1 pipeline.

“The simplest way to mitigate the potential impact of gas shortages on portfolios is to be cognisant of the companies with high energy bills as a percentage of income – especially where the energy isn’t provided by renewable sources,” Bolton said.

“The energy needs of the European chemical industry were equivalent to 51 million tonnes of oil in 2019. More than one-third of this power is supplied by gas, while less than 1% comes from renewables.”

Some larger companies may be able to weather a period of gas shortage by hedging energy costs, meaning they pay below the daily “spot” price, Bolton highlighted. Also essential is the capacity to pass rising costs on to consumers.

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However, smaller companies without the sophisticated hedging techniques or pricing power may struggle, he suggested.

“We have to be especially careful when companies that may seem attractive because they are ‘defensive’ – they have historically generated cash despite slow economic growth – have a significant, unhedged exposure to gas prices,” Bolton said.

“A medium-sized brewing company might expect alcohol sales to hold up during a recession, but if energy costs are unhedged then it’s hard for investors to be confident on near-term earnings.”

BlackRock is focusing on companies in Europe with globally diversified operations that shield them from the impact of the continent’s gas crisis, while Bolton suggested that of those concentrated on the continent, companies with greater access to Nordic energy supplies will fare better.

If price increases fail to temper gas demand and rationing becomes necessary in 2023, Bolton suggested that companies in “strategically important industries” — renewable energy producers, military contractors, health care and aerospace companies – will be allowed to run at full capacity.

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“Supply-side reform is needed to tackle inflation, in our view. This means spending on renewable energy projects to address high energy costs,” Bolton said.

“It also means companies may have to spend to strengthen supply chains and address rising labour costs. Companies that help other companies keep costs down are set to benefit if inflation stays higher for longer.”

BlackRock sees opportunities here in automation that reduces labor costs, along with those involved in electrification and renewable energy transition. In particular, Bolton projected soaring demand for semiconductors and raw materials such as copper to keep up with the electric vehicle boom.

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Image and article originally from www.cnbc.com. Read the original article here.

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