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HSBC Warns Investors to Avoid European Stocks Amid Concerns Over Economic Growth

Willem Sels, global CIO at HSBC Private Banking and Wealth Management, has advised investors to avoid allocating to Europe in the hunt for value stocks. Sels cites the continent’s energy crisis as a key reason for this, noting that the risk-reward is still not there.

September 23, 2022
9 minutes
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Willem Sels, global CIO at HSBC Private Banking and Wealth Management, has advised investors to avoid allocating to Europe in the hunt for value stocks. Sels cites the continent’s energy crisis as a key reason for this, noting that the risk-reward is still not there.

The economic outlook in Europe is not looking good as supply disruptions and the impact of Russia’s war in Ukraine on energy and food prices continue to stifle growth. Central banks are being forced to tighten monetary policy aggressively in order to rein in inflation.

Investors have typically turned to European markets in search of value stocks when trying to weather volatility by investing in stocks offering stable longer-term income. Value stocks are companies that trade at a low price relative to their financial fundamentals. By investing in value stocks, investors can protect themselves from short-term market volatility and generate income over the long term.

The U.S. offers a large number of well-known growth stocks - companies that are expected to grow earnings at a faster rate than the industry average. This contrasts with other markets where such stocks may be harder to find.

Sels suggested that although Europe may be a cheaper market than the U.S., the differential between the two in terms of price-to-earnings ratios does not make up for the additional risk involved.

Sels told CNBC last week that the emphasis should be on quality, rather than style bias, when making investment decisions. He noted that there is a significant quality differential between European and US companies, and that this should be taken into account when choosing between growth and value stocks.

I believe that investors should not base their investment decisions on geographical factors such as cheaper valuations or interest rate movements. Instead, they should focus on the economic outlook and earnings potential of the companies they are considering investing in.

Analysts are expecting earnings downgrades to dominate in the short term, as earnings season kicks off next month. Central banks remain committed to raising interest rates to tackle inflation, even though this may cause economic strife and possibly recession.

Nigel Bolton, Co-CIO at BlackRock Fundamental Equities, said that the energy crisis will lead to an economic slowdown, higher inflation, and more public and private spending. He added that the long-term effects of the crisis will be felt for years to come.

In a fourth-quarter outlook report published Wednesday, Bolton suggested that stock pickers can seek to capitalize on valuation divergences across companies and regions. However, he noted that they will have to identify businesses that will help provide solutions to rising prices and rates.

In the last quarter, stronger-than-expected inflation reports have led to increased pressure on central banks to raise interest rates. This has made the case for buying bank stocks stronger, as higher rates can lead to increased profits for banks.

Europe is working to diversify its energy sources, after previously relying on Russian imports for 40% of its natural gas. This need was made more urgent early this month when Russia’s state-owned gas company Gazprom cut off gas flows to Europe via the Nord Stream 1 pipeline.

According to Bolton, the best way to protect your portfolio from the potential effects of gas shortages is to be aware of which companies have high energy costs as a percentage of their income. This is especially important for companies that get their energy from non-renewable sources.

The European chemical industry used the equivalent of 51 million tonnes of oil in 2019. More than one-third of this power came from gas, while less than 1% came from renewables.

Bolton noted that some larger companies may be able to weather a period of gas shortage by hedging energy costs, meaning they pay below the daily "spot" price. He also emphasized that it is essential for these companies to have the capacity to pass rising costs on to consumers. However, smaller companies that don't have sophisticated hedging techniques or pricing power may struggle, according to the article.

Bolton warned that investors need to be careful when considering companies that may seem like a good investment because they are "defensive" and have generated cash even during periods of slow economic growth. He cautioned that these companies may have a significant unhedged exposure to gas prices.

A medium-sized brewing company's alcohol sales might not be as affected by a recession, but if energy costs are not hedged, it is difficult for investors to have confidence in the company's near-term earnings.

BlackRock is focusing on companies in Europe with globally diversified operations that shield them from the impact of the continent’s gas crisis. Bolton suggested that of those concentrated on the continent, companies with greater access to Nordic 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, health care and aerospace companies - will be allowed to continue operating at full capacity. This would ensure that these industries can continue to provide essential services and products.

In our view, supply-side reform is needed to tackle inflation. This means spending on renewable energy projects to address high energy costs, Bolton said.

Companies may have to spend more to strengthen their supply chains and address rising labor costs if inflation stays higher for longer. Companies that help other companies keep costs down are set to benefit from this situation.

BlackRock believes that there are opportunities for cost savings through automation, as well as through the electrification and transition to renewable energy. In particular, BlackRock projects that there will be strong demand for semiconductors and raw materials such as copper to support the growth of electric vehicles.

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