HSBC warns investors to avoid European stocks in search of value

Investors should avoid investing in Europe in the hunt for value stocks as the continent’s energy crisis means the risk-reward ratio 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 aggressively tighten monetary policy to contain inflation.

Typically, investors look to European markets for value stocks – companies that are trading at a low price relative to their financial fundamentals – when trying to weather volatility by investing in stocks that provide stable long-term income.

In contrast, the US offers an abundance of big-name growth stocks – companies are expected to increase earnings at a faster rate than the industry average.

Although Europe is a cheaper market than the United States, Sels suggested that the discrepancy between the two in terms of price-earnings ratios – the valuations of companies based on their current stock price relative to their earnings per share – does not “compensate for the extra risk you take.”

“We think the focus should be on quality. If you’re looking for a style bias and you’re going to make the decision based on style, I think you should look at the quality differential between Europe and the United States, rather than growth relative to value one,” Sels told CNBC last week.

“In fact, I don’t think clients and investors should be looking to do country allocation based on style – I think they should do it based on your economic outlook and your earnings outlook, so I would caution against buying Europe due to lower valuations and interest rate movements.”

With earnings season set to kick off in earnest next month, analysts generally expect earnings downgrades to dominate around the world in the near term. Central banks remain determined to raise interest rates to fight inflation while acknowledging that this can cause economic turmoil or even a recession.

“We are seeing an economic slowdown, higher and longer inflationary pressures and increased 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. .

However, in a fourth-quarter outlook report released on Wednesday, Bolton suggested that stock pickers may seek to take advantage of valuation discrepancies between companies and regions, but will need to identify companies that will help provide solutions. rising prices and rates.

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

Beware of “energy guzzlers”

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

“The easiest way to mitigate the potential impact of gas shortages on portfolios is to know which companies have high energy bills as a percentage of revenue, especially when energy is not supplied 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 a third of this electricity is supplied by gas, while less than 1% comes from renewable energies.”

Some large companies might be able to weather a period of gas shortages by covering energy costs, meaning they pay below the daily “spot” price, Bolton pointed out. The ability to pass on rising costs to consumers is also essential.

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

“We need to be particularly careful when companies that may appear attractive because they are ‘defensive’ – they have historically generated cash despite slow economic growth – have large, unhedged exposure to gasoline prices,” he said. said Bolton.

“A mid-sized brewing company can expect alcohol sales to hold up during a recession, but if energy costs aren’t covered, it’s hard for investors to have confidence in short-term profits. term.”

BlackRock focuses on companies in Europe with globally diversified operations that shield them from the impact of the gas crisis on the continent, while Bolton suggested that among those focused on the continent, companies with a better access to northern 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, healthcare companies and aerospace – would be allowed to operate at full capacity.

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

“It also means businesses may have to spend to strengthen supply chains and deal with rising labor costs. Businesses that help other businesses cut costs stand to benefit if inflation stays high longer.”

BlackRock sees opportunities in automation that reduce labor costs, as well as those involved in electrification and the transition to renewable energy. In particular, Bolton predicted growing demand for semiconductors and raw materials such as copper to follow the electric vehicle boom.