A focus on resilience in Europe

Although corporate profits might yet come under pressure, Sam Morse, portfolio manager of the Fidelity European Trust, believes the market has discounted much of the bad news, and there is a sense that the worst may already be priced in.

Key points

• He believes the outlook for European equities remains uncertain and conventional wisdom suggests that corporate earnings could be the next to fall.
• However, he thinks much of this is already priced into markets, which often look six months in advance and can sometimes start to recover before earnings reach the bottom or the economy starts to recover.
• Ultimately, it is impossible to predict the direction of the market, and we will continue to focus on attractively valued companies with strong balance sheets that should be resilient, and able to grow their dividends, in a more difficult economic environment.

The European equity market has fallen considerably from its high in early January, especially if you recalibrate into US dollars and look at it in real terms. Earnings, however, have held up better so far, supported by a weak euro. The typical market narrative is that the earnings shoe is about to drop and, when it does, the market will see another lurch down. The market has, of course, already discounted much of this bad news. Ultimately, we never know when or why the market bottom will be hit, but often it arrives inexplicably early (some months or quarters before the economy or earnings recover). The sense that the worst is already priced in is particularly true in today’s market, which has anticipated a recession and a decline in earnings for some time. As such, we may be nearing the end of the discounting phase - although exactly when that will be is very hard to call.

What could surprise markets in 2023?

When sentiment is so depressed, maybe one should consider what might go right? Many bulls say it’s simple: it’s all about the Fed. A pivot, perhaps, to a less aggressive tightening stance once inflation appears more under control?

Others might point to geopolitics: there remains a chance that a peace of sorts will be hashed out in Ukraine. Maybe China will come roaring back as monetary and fiscal easing combine with an end to the zero Covid policy? Or perhaps European governments will support consumers with more fiscal generosity.

The one reliable prediction is that we should expect the unexpected. In the words of Fidelity’s Peter Lynch: “nobody can predict interest rates, the future direction of the economy or the stock market. Dismiss all such forecasts and concentrate on what’s actually happening to the companies in which you’ve invested.” This is precisely what we will continue to do as it gives us the best foundation to respond to the unexpected.

Positioning for what lies ahead in 2023

Our portfolios remain balanced in terms of sector positioning and our focus is on finding attractively valued companies with good prospects for cash generation and dividend growth over the longer term. Our positioning is driven by opportunities at the individual stock level rather than by macro developments, as we believe that calling the bottom of the market is a difficult and often impossible task.

We have, however, started to cautiously increase our exposure to some companies that have performed poorly recently and now look particularly attractive. This includes some companies in the financials and industrials sectors that have the potential to do well in a cyclical recovery but have the balance sheet strength and pricing power to weather any macroeconomic uncertainty. Conversely, we are wary of companies that have historically demonstrated limited pricing power and are therefore more exposed to margin pressure, as well as those that are overly leveraged and could struggle as interest rates continue to rise. 

The portfolios’ outperformance this year has broadly been in line with our expectations, given that our focus on high quality businesses means the portfolios tend to do relatively well in weaker macroeconomic environments and typically outperform in falling markets. We have also benefited from takeover bids for two of the portfolios’ holdings.

Past Performance

Although this could simply be seen as good fortune, we do think that it is indicative of the fact that we tend to hold good quality companies trading at attractive valuations. Other portfolio holdings that have performed well this year have been those that are beneficiaries of rising interest rates and higher commodity prices, or those that have strong pricing power and have seen demand hold up.

Balance sheet strength and pricing power are two key elements that we have been focusing on over the past year and will continue to do so in 2023, with a particular focus on the underlying fundamentals of a business and the ability to weather a weaker demand environment.  

Sustainability considerations

We expect sustainability to continue to play an ever-increasing role in influencing asset flows and share price returns. Europe as a region typically has high standards of governance when compared to other markets and, within this, the portfolios screen well - around 90% of the portfolios are rated A or higher by MSCI as of the end of September 2022.

Our focus on the sustainability of dividends typically leads us to favour the types of companies that are highly rated on ESG and sustainability grounds, as companies that exhibit sustainable growth characteristics and pay attractively growing dividends tend to have good business practices.

Important information

Past performance is not a reliable indicator of future returns. The value of investments and the income from them can go down as well as up, so you may get back less than you invest. Investors should note that the views expressed may no longer be current and may have already been acted upon. Overseas investments are subject to currency fluctuations. Fidelity European Trust PLC can use financial derivative instruments for investment purposes, which may expose it to a higher degree of risk and can cause investments to experience larger than average price fluctuations. The shares in the investment trust are listed on the London Stock Exchange and their price is affected by supply and demand. The investment trust can gain additional exposure to the market, known as gearing, potentially increasing volatility. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to an authorised financial adviser.

The latest annual reports, key information document (KID) and factsheets can be obtained from our website at www.fidelity.co.uk/its or by calling 0800 41 41 10. The full prospectus may also be obtained from Fidelity. The Alternative Investment Fund Manager (AIFM) of Fidelity Investment Trusts is FIL Investment Services (UK) Limited. Issued by Financial Administration Services Limited, authorised and regulated by the Financial Conduct Authority. Fidelity, Fidelity International, the Fidelity International logo and F symbol are trademarks of FIL Limited. UKM1122/380770 D/ISSCSO00103/NA