EUROPEAN LONG/SHORT JANUARY 2016

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1 EUROPEAN LONG/SHORT JANUARY 2016 FOR PROFESSIONAL CLIENTS ONLY There was certainly no shortage of talking points for investors in Monetary easing, low oil prices and political upheaval drove investor sentiment, while further afield, China s slowdown and anticipation over US interest rate rises also had an impact. Michael Browne and Steve Frost reflect on the last 12 months for European equities and consider what lies ahead for Michael Browne Portfolio Manager European Long/Short How did your strategy perform in 2015? We are pleased to see that our 2015 strategic approach, which we set out in December 2014, played out as we predicted. Then, our view on key drivers and strategy was that a rising US dollar would hurt emerging market growth. This, coupled with falling commodity prices would be a deflationary force, affecting capital expenditure across the board beyond just oil companies. In terms of the macro backdrop, the transmission of quantitative easing (QE) has not worked as well as the European Central Bank (ECB) had hoped. Banks have been increasing deposits at the ECB, and loans to non-financial borrowers have not risen. ECB President Mario Draghi s announcement on 3 December was therefore disappointing, as it failed to address these issues. The outcome of our strategic approach in 2015 meant that we were able to manage market volatility well. We did experience frustrating periods during the year, especially when markets staged strong short-term rallies (on the Steve Frost Portfolio Manager European Long/Short hope of better growth and corporate profitability). However, the consistency of our approach meant that we were rewarded by lower volatility than the market. In particular, we benefited from market weakness, capturing material alpha from our short positions. With regard to portfolio management, we sold in rallies and bought in weakness.

2 active OUTLOOK: EUROPEAN LONG/SHORT Did you make any significant changes to the portfolio in 2015? Throughout 2015 we maintained a policy of generally investing in stable longercycle cash-generative businesses and shorting weaker short-cycle business models. In late July, as Chinese and other emerging markets slowed sharply (which began to influence European corporate results), we cut net exposure, only rebuilding once markets had become oversold. We increased exposure by taking profits in shorts and adding higher-quality industrials before later taking profit in order to reduce our net position. We again cut net exposure in late September on worries regarding the potential rise in US interest rates, the expected material correction eventually happened in December. For most of the year, the gross exposure has remained stable. What will the key drivers be for your market in 2016? As in 2015, the key drivers will continue to be the US dollar s effect on capital flows out of emerging market economies and the deflationary effect of falling commodity prices. These factors were the main negative catalysts last year. The big question is, will they continue to weigh on markets? In 1994, as the US Federal Reserve (Fed) was increasing interest rates while other central banks cut theirs, the dollar weakened. If this happens in 2016, the pressure on emerging markets and commodities will lessen and these asset classes could rebound. Other major drivers will be lingering poor corporate confidence and the high-yield debt market which has been weak in recent months. Politically, the major talking point during 2016 will be the UK s potential exit from the European Union in If this were to happen, the initial reaction is likely to be for sterling to weaken and perhaps a correction in the UK equity market. European economic growth will very much depend on the global growth picture. If this slows, Germany is likely to feel the negative effects more, due to its significant reliance on industrial exports. In your opinion, what are the key risks facing your markets in 2016? Although the majority of company valuations are not cheap, we could see markets eventually discount the weaker global macro picture. We believe there is only so long that equity valuations can be helped by the low yields in the bond markets. A risk at some point in the future, perhaps 2017/2018, is an inflationary spike due to a tightening in the supply side of commodities. This would materially hurt bond markets (and therefore the valuations of those business models with long-term cash flows) while initially equity markets would be likely to weaken as well. As a result of this spike, the concern would then be that central banks, notably the ECB, would need to raise interest rates as a reaction to inflationary pressures. Despite the US and UK growing faster than other western economies, there may be a risk that the fiscal and monetary tightening seen in 2015 slows growth more than expected. Can you comment on the consensus economic outlook and earnings expectations for your market? European purchasing managers indices (PMIs) have been in expansionary territory for several months, initially helped by service industries. In recent months, European manufacturing PMIs have improved further, responding to the benefits of the euro s collapse. While the UK is seeing solid growth and Germany is also improving, the French economy continues to underperform. Consensus forecasts are for similar growth in 2016, further helped by the region s competitiveness and some effects of the ECB s QE programme.

3 PAGE 3 How do current valuations look in your market relative to history/other markets? Valuations remain higher than the longterm average, as markets have risen strongly since However, earnings have been flat, therefore valuations continue to climb upwards. How challenging is it to invest in this low-growth environment? How has this affected investment decisions? Our long/short strategy continues to benefit from a low-growth environment, notably for short ideas where profit and cashflow and structurally weak industries remain under pressure. In this economic scenario, our strategy will benefit from the ability to commit capital at more interesting market levels, when sentiment is weak and valuations attractive. Are there any particular sectors or areas that you are currently researching? What investment ideas excite you at the moment? We continue to research Europeanfocused business models, particularly those which are growing at a faster rate than GDP, with strong market share, pricing power and a low risk of being affected by problems from emerging markets. We will also be increasing focus on restructuring companies which are taking the right steps to materially improve their financial health and profitability. Our long/short strategy continues to benefit from a lowgrowth environment notably short ideas where profit and cashflow and structurally weak industries remain under pressure. European Scenarios in 2016 Every year we like to give our view on the chances of different scenarios occurring and explain how we would position our portfolio and balance sheet in such environments. The general investment sentiment towards equities is the lowest we have witnessed at the start of any new year since January Markets will, of course, react poorly to weak results and economic conditions. However, the backdrop of deflationary and emerging market concerns is now somewhat built into expectations. Therefore, if there are signs of improvement we should see markets perform well on the upside. Bull Market (25% likelihood) The big question is how does the global economy respond to US rate rises? If the US economy continues to grow at the expected rate and the progress of further increases are at a measured pace, credit markets could take this in their stride. The US dollar may stop strengthening, while commodities and emerging market currencies could stabilise and perhaps even recover. Under this scenario, equityrisk premiums are likely to fall, bond-yield curves will normalise and yields are likely to rise, as investors look to switch from lower-risk assets to equities. Markets will then be able to focus on earnings and GDP growth again. We could see good opportunities in buying quality cyclicals as volume growth should improve and deflationary pressures on product prices would abate. Trading Range (approximately 50% likelihood) With sub-trend global growth, increasing deflationary pressures and rising risks in the credit market, it is likely that for the third year running we would see a volatile equity market, with strong rallies and a number of periods with swift corrections of 5% 15%. We would continue our 2015 strategy of focusing on investing in strong business franchises while shorting weaker businesses, notably those with extended balance sheets. We would welcome significant market weakness as a reason to increase net exposure to more than 60%, as valuations would look more appealing. Bear Market (20% likelihood) Under this scenario, global growth would slow more than expected, affecting all economies, including the US and China but notably emerging markets. Credit spreads would widen and deflationary pressures would increase. A banking crisis would become likely and equity markets could well fall by 20 30%. We would maintain a low or even negative exposure with a high-net short exposure to weak industrials, cyclicals and financials, expecting major profit warnings in a number of quarters. We would take long positions that are likely to outperform short-cycle businesses. We would be very careful when increasing net exposure, as markets would eventually fall to new lows. Collapse (5% likelihood) This scenario could be triggered by a bond-market collapse due to high-yield problems, a Chinese hard landing or the break up of the eurozone. Markets would fall by 30 40%. Our strategy would focus purely on capital preservation, with a low gross and net exposure.

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