Now is the time to invest in European equities Martin Skanberg, Fund Manager, European Equities

September 2013 European equities have been supported by European Central Bank president Mario Draghi’s pledge in summer 2012 that he would do ‘whatever it takes’ to preserve the euro. That remark, and the accompanying ECB policy action, has helped to restore confidence in the eurozone and has driven share price gains. Nonetheless, we believe that there remains scope for European equities to build on this upward momentum. The recent upturn in economic activity in the eurozone should see domestic earnings play a greater role in propelling equities higher. Martin Skanberg Fund Manager

Economic activity picking up in Europe

It is clear from economic data released over the summer that the European economy has reached a turning point. The eurozone emerged from recession in the second quarter of 2013, posting a growth rate of 0.3% versus the first quarter. While growth remains unevenly spread across the single currency area, it was encouraging to see that the biggest upside surprise came from Portugal, which posted growth of 1.1%. Regional powerhouse Germany continued to experience healthy expansion at 0.7%. Leading indicators such as purchasing managers’ surveys provide further cause for optimism regarding the eurozone’s future prospects. Markit’s eurozone composite PMI index rose to 51.5 in August from 50.5 in July, representing the fastest rate of growth in just over two years. The survey also showed that the economic recovery is looking increasingly broad-based: the PMIs showed that both Spain and Italy moved out of contraction territory in August, halting periods of decline that began in May 2011. Furthermore, the euro area’s business climate indicator rose for a fourth successive month in August and even consumer confidence is on the rise. European consumer confidence 1,800

5

1,600

0 -5

1,400

-10

1,200

-15 1,000

-20

800

-25

600

400 Jun-93

-30 Jun-95

Jun-97

Jun-99

Jun-01

MSCI Europe – Price Index (lhs) Source: Thomson Reuters Datastream. As of August 15, 2013

Jun-03

Jun-05

Jun-07

Jun-09

EK Consumer Confidence Indicator

Jun-11

-35 Jun-13

Talking Point

The European Central Bank (ECB) has played a key role in taking bold policy decisions which have restored confidence and should further support the broader European economy. Despite the positive signs emanating from Europe, it is doubtful that the ECB would consider tightening monetary policy anytime soon, especially given that they have only just embarked upon the policy of providing ‘forward guidance’, promising not to raise rates for an extended period as long as inflation remains below the 2.0% target. PIIGS making progress We have passed the point of ‘peak austerity’ in the eurozone and the tough measures taken by some European countries are now feeding through. Labor costs have started to converge across the single currency area with Spain and Ireland in particular making progress on this front. The result is that Europe as a whole is becoming more competitive. Germany remains competitive even with recent wage increases of 5-6%. These wage rises are beneficial as the rise in disposable incomes will fuel demand for consumer goods and help domestic consumer-facing companies. Meanwhile, aided by its improved competitive position, Spain saw a 6% rise in exports in the second quarter, after a 3.8% decline in the previous quarter. In addition, the gap is narrowing between those countries running current account deficits and those running surpluses. Spanish finance minister Luis de Guindos recently said that he expects Spain’s current account for 2013 to show a surplus of around 2% of GDP. The improved structural position of many southern European economies means they are less vulnerable to solvency shocks. Converging unit labor costs across the eurozone Indexed 2000 Q1 = 100 150 140 130 120 110 100

90 2000

2001

2002

Germany

2002

2003 France

2004

2005

Ireland

2006

2007

Italy

2008 Spain

2009

2010 Greece

2011

2012 Portugal

Source: Haver, Goldman Sachs Global ECS Research, as of December 31, 2012

Political risks receding Progress on resolving the euro crisis has been interrupted several times by general elections. Last year’s Greek elections and this year’s Italian vote were particular flashpoints, delivering unclear outcomes as voters expressed their discontent with austerity. In turn, those unclear outcomes cast doubt on whether the incoming governments would be willing or able to undertake much-needed reforms, and therefore dented investor confidence. The focus recently has been on the outcome of the German election. After that, Europe does not face another major election until 2017, which should provide the breathing room needed for leaders to focus on issues such as moving towards fiscal union. There may be flare-ups along the way – and there could certainly be some noise from Italy as the political death throes of Silvio Berlusconi play out. We saw political turmoil in Portugal this summer due to the resignations of the finance and foreign ministers. Markets feared that the governing coalition would be destabilized and find it hard to drive through the remainder of the bailout program. Portugal’s 10-year bond yields spiked to around 8.0% and its stock market saw a sell-off amid the uncertainty, but the rise proved short-lived. Importantly, the concerns over Portugal did not spread to other nations on the periphery.

2

Talking Point

Growth to boost domestic-focused stocks The more stable economic and political landscape enjoyed by the eurozone over the last year has already been reflected in share prices to some extent. Nonetheless, European equities remain cheap relative to other regions, especially when compared to US equities which have enjoyed a strong run. In addition, not all European stocks have participated equally in the gains made over the past year. Quality growth stocks, such as food staples with strong brands and exposure to international markets, have led share price gains. These stocks benefited from their exposure to emerging markets, and to growth in the US. However, these companies are now looking expensive and are vulnerable to slowing growth in emerging markets. They are also having to invest more in advertising and promotion in order to achieve sales growth. By contrast, companies exposed to Europe, and the euro area in particular, have been left behind. These are the stocks which now look likely to deliver the greatest returns. As a result, we prefer companies with exposure to Europe over those more exposed to emerging markets, and within Europe we see opportunities in some southern European markets. Relative performance of European stocks with different regional exposures of revenues 120 115 110 105

100 95 90 85 80

75 Jan-07

Jul-07

Jan-08

Jul-08

Jan-09

EM exposed

Jul-09

Jan-10

Euro are exposed

Jul-10

Jan-11

Jul-11

US exposed

Jan-12

Jul-12

Jan-13

Jul-13

Europe exposed

Source: UBS European Equity Strategy. Data as of August 19, 2013. Past performance is not a guide to future performance. The value of investment can go down as well as up and is not guaranteed. Regions shown for illustrative purposes only and should not be viewed as a recommendation to buy/sell.

The increase in European share prices over the past twelve months can be attributed to the removal of the ‘crisis discount’ imposed by investors as the eurozone lurched from one bailout to another. As the risk of another crisis event recedes, investors can now focus on the second leg of the equity story: the prospect of a domestic earnings recovery.

The second leg of the European equity story is the domestic earnings recovery.”

Seeking mispriced opportunities As well as looking good value when compared to other regions, European equities are also trading on attractive valuations relative to history. Some of the more defensive areas of the market, such as consumer staples, have become expensive as a result of the search for safe havens and dividend yield. By contrast, certain sectors - including telecoms, financials and utilities - are trading well below their historical average P/E ratios. Valuation alone is rarely enough to determine our decision to invest in a company. We undertake detailed research to identify the best opportunities available, seeking out an inflection point or ‘change story’ that is not yet incorporated into the market price. There are many companies across Europe that have taken the opportunity over the past few years to cut costs and restructure their businesses, and thus face the future in good shape. In particular, those companies with strong, market-leading franchises in their domestic markets are well-placed to benefit from the nascent economic

3

Talking Point

recovery. In addition, Europe is home to some unique assets – for example, in the luxury goods sector – which investors would not be able to replicate in other regions. Graham & Dodd P/E European sectors Max 80x

50

Max 147x

45 40 35 30 25 20 15

10 5 0 Health Care

Consumer Consumer Telecoms Financials Industrials Utilities Stap Disc Current Average

Materials

Energy Technology

Total

Source: Thomson Reuters Datastream. Based on data from December 31, 1982 to June 30, 2013. Sectors shown for illustrative purposes only and should not be viewed as a recommendation to buy/sell

The recent uptick in merger and acquisition activity in Europe indicates that corporates themselves are alive to the opportunities on offer in some of these sectors. Improved credit conditions and an increase in business confidence have also supported the revival of M&A. The telecoms sector is a case in point, with the sector now coming back to life after being shunned by investors. Valuations in the sector became depressed as firms struggled against headwinds such as high debt, increased regulation and austerity-hit customers becoming increasingly cautious with their spending. Yet, with companies strengthening their balance sheets and pressure on consumers starting to abate, competitors have seized the opportunity to pick up assets at cut-price valuations. In some cases this is to strengthen their offering in individual markets, such as Vodafone’s acquisition of Kabel Deutschland or Telefonica Deutschland’s offer for E-Plus, while others are seeking to cement their exposure to Europe, as is the case with America Movil’s offer for KPN. Meanwhile, AT&T’s interest in European telecoms assets is well-known. Low earnings expectations in Europe 25

120

20

100

15

80

10

60

5

40

0 Jun-88

20 Jun-91

Jun-94

Jun-97

Jun-00

MSCI EMU 12m Fwd EPS (lhs) @:M1EMU(A12FE)

Jun-03

Jun-06

Jun-09

Jun-12

MSCI US 12m Fwd EPS (rhs) @:USMSCIP(A12FE)

Source: Thomson Reuters Datastream. As of August 30, 2013

The cheap valuations in Europe currently are a reflection of how depressed earnings have been. European equity earnings are still 40% below their 2006 peak and expectations remain very low, particularly in contrast to the US where

4

Talking Point

forward earnings expectations have already surpassed their previous peak. The sector where earnings have been most depressed in Europe is financials, which in turn now looks set to enjoy the strongest earnings growth. As European GDP grows and sales recover, we will see an acceleration of earnings momentum in Europe. The earnings gap with the US should start to close and there is the prospect that Europe could reach a new earnings peak in 2016. Sectors such as financials, energy and telecoms are poised to lead this earnings recovery, as they have been most structurally challenged. As well as top-line growth coming from a re-acceleration of GDP growth, improvements in funding rates should feed through to profit margin expansion. There are therefore clear opportunities for investors to take advantage of the mispriced opportunities available in Europe. Peripheral Europe in particular has been out of favor due to the perceived risks of investing there. Nonetheless, we believe that there are many opportunities at a stock level where the remaining risks are already priced in, and where the potential returns are greatest. The advantage of a fund with no particular style bias is that we have the freedom to avail ourselves of the potential returns offered by these pricing anomalies. We are not limited to choosing between quality and value, but can shift the focus of the portfolio to capture the best opportunities, wherever they are found. Some risks remain Clearly, Europe is still grappling with the effects of the crisis and high unemployment in several countries remains a real cause for concern. Greece’s unemployment rate hit a new high of 27.9% in June, with youth unemployment close to 60%. Although the eurozone has exited recession, growth remains precarious and not just in the periphery. Indeed, the Netherlands, part of ‘core’ Europe, experienced a 0.2% contraction in GDP during the second quarter of 2013. One remaining area of risk is the credit cycle which has not turned yet. This is partly due to weak demand but also to lack of supply, as banks shrink their loan books. While GDP has stabilized, we would need to see a sustainable turn in the credit cycle to push GDP growth higher. According to the European Central Bank, demand for credit is on the rise. This is a situation that we will continue to monitor. The European Central Bank has pledged to keep monetary policy accommodative, but external risks remain a threat. While the Federal Reserve decided against tapering its quantitative easing program in September, when it does happen its impact will be felt in Europe too. Nonetheless, we feel that these risks are well-known and are outweighed by the potential rewards available. Detailed stock analysis helps us to identify which opportunities are likely to generate the best returns.

5

Talking Point

Important Information: The views and opinions contained herein are those of Martin Skanberg, fund manager, European equities and do not necessarily represent Schroder Investment Management North America Inc.’s house views. These views are subject to change. This newsletter is intended to be for information purposes only and it is not intended as promotional material in any respect. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument mentioned in this commentary. The material is not intended to provide, and should not be relied on for accounting, legal or tax advice, or investment recommendations. Information herein has been obtained from sources we believe to be reliable but Schroder Investment Management North America Inc. (SIMNA) does not warrant its completeness or accuracy. No responsibility can be accepted for errors of facts obtained from third parties. Reliance should not be placed on the views and information in the document when taking individual investment and / or strategic decisions. Securities/sectors/regions mentioned are for illustrative purposes only and should not be viewed as a recommendation to buy/sell The information and opinions contained in this document have been obtained from sources we consider to be reliable. No responsibility can be accepted for errors of fact obtained from third parties. The opinions stated in this document include some forecasted views. We believe that we are basing our expectations and beliefs on reasonable assumptions within the bounds of what we currently know. However, there is no guarantee that any forecasts or opinions will be realized. Schroder Investment Management North America Inc. (“SIMNA Inc.”) is an investment advisor registered with the U.S. SEC. It provides asset management products and services to clients in the U.S. and Canada including Schroder Capital Funds (Delaware), Schroder Series Trust and Schroder Global Series Trust, investment companies registered with the SEC (the “Schroder Funds”.) Shares of the Schroder Funds are distributed by Schroder Fund Advisors LLC, a member of the FINRA. SIMNA Inc. and Schroder Fund Advisors LLC. are indirect, wholly-owned subsidiaries of Schroders plc, a UK public company with shares listed on the London Stock Exchange. Schroder Investment Management North America Inc. is an indirect wholly owned subsidiary of Schroders plc and is a SEC registered investment adviser and registered in Canada in the capacity of Portfolio Manager with the Securities Commission in Alberta, British Columbia, Manitoba, Nova Scotia, Ontario, Quebec, and Saskatchewan providing asset management products and services to clients in Canada. This document does not purport to provide investment advice and the information contained in this newsletter is for informational purposes and not to engage in a trading activities. It does not purport to describe the business or affairs of any issuer and is not being provided for delivery to or review by any prospective purchaser so as to assist the prospective purchaser to make an investment decision in respect of securities being sold in a distribution. Further information about Schroders can be found at www.schroders.com/us. Further information on FINRA can be found at www.finra.org Further information on SIPC can be found at www.sipc.org Schroder Fund Advisors LLC, Member FINRA, SIPC 875 Third Avenue, New York, NY 10022-6225

6