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Europe: the destination for income in a rising rate environment

Simply put investors can come to Europe and invest in high quality, unique and globally leading companies trading at favourable valuations and achieve a significant uplift over the MSCI USA dividend yield of 1.6%, without giving up on quality. Even more compelling in this new environment is the alignment between what Europe does well and what works in a rising interest rate, inflationary and capex-led environment.

The MSCI Europe ex-UK index gives investors nearly double the exposure to consumer staples and industrials, and some 40% more exposure to financials than MSCI USA, at 15% vs 11% respectively.  By contrast the US, largely through its information technology sector, which stands at 28% vs 9% sector weight in Europe, holds far more high multiple growth stocks, which tend to struggle against a backdrop of rising discount rates.

Meanwhile the valuation spread between MSCI Europe ex UK (13x 2022e PE) and MSCI US (18x 2022e PE) is at decade highs.

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Europe’s high quality, globally leading, companies tend to be found across areas of the market with a similar or higher index weighting vs the US, notably: consumer discretionary (luxury and some autos), consumer staples, financials (ex-banks), healthcare, industrial technology and materials science. By focusing on these areas of excellence, investors can access returns more equivalent to MSCI US at lower multiples and achieve a >100% uplift in income.

This can be achieved while avoiding the lower-return, more capital-intensive and domestic-facing, highly cyclical and regulated sectors from which many income funds tend to derive their higher levels of dividend income. Further, these latter sectors tend to see wildly fluctuating performance or suffer regulatory intervention such as the energy and electricity price clawbacks that are now being put forward in response to the crisis.

It has been a long time since investors have been confronted by an inflationary environment characterised by rising rates, slowing growth and, in this case, a fiscally led pick-up in capex. Somewhat counter-intuitively given the tragic events unfolding in Ukraine and the related higher energy and input costs, Europe is structurally quite well positioned for this kind of environment.

Consumer staples (13% sector weight vs 7% for MSCI US), have a strong track record of passing on costs. We saw this in action again during Q1 results where Unilever passed on 8% to price against 7% growth in sales, and Nestle and Danone recorded robust demand at a higher price for vital and trusted brands like Kitkat and Actimel. Similar arguments apply to IP-rich entertainment companies like Universal Music, and also to high-end luxury brands like Mercedes-Benz and Gucci in the consumer discretionary sector where demand tends to be relatively unaffected by short-term economic headwinds.

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Due to its long history of competing city states and as a region scarce in hydrocarbon resource, Europe excels in industrial technology (with industrials 15% vs 8% in US) and is uniquely well placed to benefit from the global wave of fiscally- led capex now targeting resource efficiency and regional self-sufficiency and set to run through the next decade and beyond.

Growth may be slowing in some areas of the economy but for Europe’s globally leading industrial enablers Q1 results showed clear evidence of both the ability to pass on costs and a long-term outlook that is robust and improving. Schneider Electric cited an “acceleration of electrification, energy efficiency, electricity 4.0 and industry 4.0” alongside the need for “industrial sovereignty”. ABB and Siemens offered similarly upbeat outlooks across their dominant automation, robotics and industrial software businesses.These digital industrial enablers, characterised by high levels of recurring service revenue, are currently available at fair or even discounted multiples.

The European financials sector (ex banks) also offers plenty of high quality globally leading companies, typically with persistent high cash returns and strong balance sheets, including insurers and exchanges such as Deutsche Boerse and Euronext, which benefit from higher interest rates and also volatility in the case of the latter. Here too dividend yields are in general well above the levels on offer the other side of the pond.

This mix of high-quality cyclicals and defensives presents the opportunity to build a well-balanced portfolio that can outperform down markets and keep up in bull markets.

Most of Europe’s current inflationary bout is imported. This, combined with the region’s significantly higher labour slack versus the US (6.8% unemployment vs 3.8% in the US), which can be seen in Europe’s far lower levels of Core CPI Inflation vs the US (~3% vs 7%), means Europe looks likely to avoid the extent of rate rises set to unfold in the US.

This in turn suggests European real rates should remain low, albeit above prior levels due to the expanding fiscal focus on climate and infrastructure, and the environment for quality income should be supportive for a long-time to come. Meanwhile the successive impacts of Trump, Brexit, Coronavirus and now Russia Ukraine is working to make Europe a more politically cohesive and agile block with positive long-term investment implications for the region.

Nick Edwards is fund manager of the Guinness European Equity Income fund

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