This summer’s vote by the United Kingdom electorate to leave the European Union sent a shockwave through capital markets, with investors fearing that the action could lead to a reduction in investments in the country’s corporations, cumbersome trading restrictions, and further moderation of economic growth. The shock wave proved to be temporary and the devaluation of the country’s currency has boosted tourism and other industries, but one thing remains: growing uncertainty over the fate of the European Union and the collection of countries that use the euro currency.
Yet, in some instances, uncertainty can create conditions that allow leading portfolio managers to outperform by seeking nimble companies with strong fundamentals and innovative products that help drive rapid earnings growth. Some companies may even exploit changes by addressing demand for new products that can result from changes, including the departure of a country like the U.K. from the European Union.
In other instances, companies may have innovative products that are appealing throughout different phases of economic cycles. Assessing the economic impact of Brexit has been difficult because policymakers have yet to finalize the terms of the U.K. department from the European Union and economic data has been mixed. The U.K., however, is only one piece of the puzzle for Europe, but the significance of its Brexit vote may be that it can potentially serve as a precedent for other countries.
Indeed, as Italy’s economy continues to worsen, observers are questioning if the country may follow in the U.K.’s footsteps and also reject the Euro as its currency. Since 2007, the percentage of non-performing loans in Italy’s banking sector has climbed from 6% to 18% and the country’s debt-to-GDP ratio has reached 137%.
The country’s expected GDP growth rate, furthermore, has been revised downward to 1.2%. Yet, over the years, the country’s labor costs have climbed, a result of regulations that many observers maintain must be reformed.
Italy has a referendum scheduled to modify its constitution. As it currently stands, the referendum doesn’t address European Union membership, but some observers maintain that worsening conditions could drive the country to consider its own version of Brexit.
For Italy, leaving the European Union and dumping the Euro could allow the country to devalue its currency. By doing so, it would slash its labor costs relative to other countries and make its exports more attractive. Yet, similar broader concerns could surface because the country would have to renegotiate trade agreements, immigration rules and a host of other regulations. The lack of a single market across Europe could also be problematic.
The end result of the ongoing concerns over Italy and the fate of the European Union and the Euro is that the future of the continent remains highly uncertain. Indeed most observers are at a loss to forecast what the coming months will bring.
With that in mind, advisors should assess the merits of active managers for gaining exposure to Europe. In many instances, index funds can be attractive because the products provide diversification and low fees. Yet, in the case of Europe, advisors should consider using active portfolio managers that seek nimble companies that are capable of capturing market share and are characterized as having strong fundamentals.
While panic over markets that can result from a Brexit style vote may cause stocks of all companies in Europe to drop quickly, over time, shares of companies that are growing their earnings are likely to outperform other stocks in the aftermath of a market decline.
By having novel products that can capture market share, leading companies can also grow their earnings even when GDP growth moderates. Indeed, the U.S., while enjoying slow but steady economic growth, illustrates the potential for innovative companies to grow their earnings. This trend is clearly shown by leading online retailers and other companies such as NetFlix, Apple, Alphabet (formerly Google) that are benefiting from the rapid growth of the internet and increasing their earnings at rates that exceed the growth of the U.S.
Active managers can also seek to manage risk by ensuring that European companies have exposure to markets in a variety of countries or regions.
Advisors may also want to illustrate to their clients how active portfolio managers can potentially mitigate the risk of an uncertain future. For example, advisors can discuss how companies held by a portfolio manager have exposure to a variety of countries and why the companies have potential for growing their earnings even during uncertain economic times.