With a dramatic squeeze on household budgets, Europe is bracing for recession
With European growth at 0.2% and inflation well above the 7.5% target, Europe is bracing for the kind of stagflation it hasn’t seen in 50 years, says Sean Kenzie, head of equities at Setanta Asset Management, based in Dublin.
Kenzie said difficult economic conditions dictate the need for careful analysis and new investment strategies.
“This is the first time since the 1970s that we really have to worry about stagflation,” he said. “Fortunately, we can learn from Warren Buffett, who has written extensively on the subject.”
Using logic borrowed from the Oracle of Omaha, Kenzie pointed out that inflation does not spare capital costs like investments in plant, machinery, inventory and receivables.
“So it takes more capital per dollar of revenue and that, combined with a lower margin, gives you lower return on capital and returns on equity.”
At times like this, he said, “You really have to focus on companies with competitive advantages and pricing power; firms that set prices, not price takers.
Stagflation is often described as an economic condition in which “growth is down and inflation is up”. But Kenzie prefers the definition offered by Kristalina Georgieva, Managing Director of the International Monetary Fund. She puts a more human face on stagflation by describing it as a time when “incomes fall and hardship rises.”
“In Europe you have dramatic pressure on household budgets,” he said. “JP Morgan estimates that 40% of the UK population will spend 30% of their income on food and fuel. And after accommodation, that doesn’t really leave much for discretionary spending,” he said.
The source of inflation, he said, is correctly identified as Russia’s war on Ukraine, but is amplified by other factors, including lingering worries about Covid-19, a shrinking labor market. tightens and stubborn global supply chain issues.
“Supply chain shortages are something that we think are temporary in nature. Capitalism is used to solving these kinds of problems,” he said. “But against that assumption , there’s this ongoing fragmentation and regionalization of supply chains, and the blurring of lines between economics and geopolitics, where countries want to be sure of security around data, their communications, their technology and of their supply chains.
He said the current Russian aggression has sounded the death knell for Siberian oil and gas in Europe and will accelerate the transition to alternative forms of energy on the continent.
“Germany, for example, already had a target of getting around 80% of its electricity from new renewable resources – around double what it was in 2021 – and that is likely to increase,” he said. he declared. “The energy transition is no longer just arguments about the climate crisis. Now it is also about energy security.
Ideological polarization also remains a threat to European unity and economic health.
“Political instability in Europe is a bigger call. It seems to be a bit more vulnerable to political risks, with some protectionist elements,” he said. “It’s always a backdrop in Europe.”
Recent national elections in France, for example, only narrowly avoided the wrath of far-right candidate Marine Le Pen. Italians are expected to go to the polls within a year, with some predicting similar divisions.
But in the long run, an even more important consideration for Europe, Kenzie suggested, is sheer demographics.
“Canada is expected to add 10 million people to a base of 38 million by 2050. The United States will have 100 million more people by 2050. But the population of EU 27 is expected to remain stable on the same time horizon,” he said. mentioned. “And if you think about population growth, then in terms of building demand – people need homes to live in, places to go to work, infrastructure to connect it all, roads, bridges, airports, etc. – and all the multiplier effects that go with it, it is a structural brake on European growth.
With all of these factors, Kenzie suggested a new approach to making gains.
“Investors should have lower expectations for equity returns in this environment of tighter financial conditions and slowing growth, and stubbornly high energy prices and inflation,” he said. . “And if those high energy costs and higher wages persist, it’s the companies with pricing power and operating leverage that are able to capitalize.”
Among the European companies poised to do well is France’s EssilorLuxottica SA, the result of a 2018 merger between Italian sunglasses and frame maker Luxottica and global lens maker Essilor.
In addition to having industry-leading brands and processes, the company has purchased the Sunglasses Hut store network and partners with opticians to effectively capture prescription, retail and online sales. Kenzie also pointed out that the demand for corrective eyewear is structurally increasing, not only because populations are aging, but also because the increased use of screens is leading to a drastic change in eye degradation and a need for more corrective eyewear. .
“Essilor is at the forefront,” he said. “He spends a lot more on R&D than anyone else in the industry, and he’s a very strong leader in innovation and lens coatings so should do very well.”
Another interesting opportunity is CRH plc, based in Ireland. This building materials supplier has taken an integrated approach to infrastructure construction work that sets it apart from its competitors.
“As the management says, they like to sell the road, not the rocks. They moved away from commodities and commodity pricing to much higher value solutions,” Kenzie said. “They’re paying a cash dividend yield right now of 3% and a buyout yield of 4%. So that’s a return to shareholders of 7% a year.
The key for investors, he said, is to focus on companies’ ability to control costs and input prices in an era of high inflation and low growth.
“Once you identify those factors, you just have to be very careful not to overpay and expose yourself to multiple cuts,” he said. “If those companies with these attributes can translate these benefits into higher free cash flow conversion and increased dividend yields and shareholder returns, they should do well.”
This article is part of the Soundbites program, sponsored by Canada Life. The article was written without the contribution of the sponsor.