Why Europe offers an attractive mix of quality and value

Company management meetings and site visits are integral to our investment process, and where possible, we look to visit core regions at least annually. 2022 was our first trip post COVID, and was a particularly unique trip given the breadth of headline issues facing both Europe and the UK – including the Russia-Ukraine war, lingering COVID overhangs, the ongoing energy crisis, rampant inflation, travel chaos and a worsening economic environment. It was interesting to be back on the ground this year and see what concerns had dissipated, and what was still causing sleepless nights.

Economy

The economic outlook across Europe remains uncertain. Although an energy-led collapse seems to have been avoided, mixed data continues to make policy response very difficult.

It would be easy to be negative in an environment of higher inflation and costs, interest rates still below peak, declining savings rates, less supportive fiscal policy, lower overall liquidity, and a volatile global landscape. However, households keep on consuming, corporates continue to raise prices and invest in growth and employment, while worked hours and unemployment readings continue to reflect a strong labour market.

Global activity and the re-opening of China has been slower than expected, further weighing on industrial activity and the manufacturing sector, while the services sector remains relatively buoyant. This disparity in domestic economic drivers is favouring certain countries over others (for example, Spain over Germany). Overall, GDP growth has been muted and is expected to remain so through 2023 and into 2024.

Inflation, while still elevated, does look to have peaked (subject to energy and a winter weather outlook). However, it is proving to be sticky at elevated levels, with the decline very gradual to date. Despite consensus forecasts seeing a reversion to targets in 2024, the trend certainly doesn’t suggest this will be realised that quickly. As such, we remain overweight inflation which we look to capture and compound in our earnings models.

While the data and outlook are certainly not robust, our experience, as we travelled through the various markets, was of consumption. People were travelling, eating out, and spending.

Maybe this is partly due to us being largely in big cities and this could be very different outside urban areas where affordability has hit harder. It could also be prolonged post-COVID “revenge spending”, which could dissipate over time as savings rates continue to deteriorate. However, we also think it could be partly structural – having survived COVID and its associated lockdowns and furloughs, consumers and corporates alike are aware that in dire situations they can survive with the help of government handouts. 

The need to “save for a rainy day” is being perceived as far less important than “living in the moment”.

Whatever the case, the conflicting signs certainly make the central banks’ job harder, and it does feel like this time around things could be different.

Infrastructure

While much is happening across the infrastructure landscape, this trip really highlighted and reinforced some strong thematics, including:

• Travel: the pent-up demand continues despite macroeconomic headwinds. Unlike last year, the user experience has vastly improved, with less disruption from delays, strikes and staff shortages.
• Energy: the long-term outlook for utilities remains particularly strong, with the energy transition gaining traction amidst the ongoing Russia / Ukraine conflict. While Europe seemingly navigated the energy crisis last year, and the discussions this year had a very different focus, it’s not fully out of the woods just yet
• Government intervention: government intervention has lessened in the utility space, but threat of intervention is increasing in other sectors. Ongoing cost of living difficulties are putting pressure on governments to act.

Traffic recovery supported by strong demand

Ongoing post-pandemic traffic momentum was confirmed by all management teams. While several European airports had already moved the anticipated timeline to recover passenger numbers to pre-pandemic levels forward, a few now expect it to happen by year end, with several monthly traffic prints already exceeding equivalent numbers pre-pandemic. For example, AENA (the Spanish airport operator) has a FY23 traffic guidance of 94-104% of 2019, but has recently said final numbers would be closer to in-line or above 2019.

This ongoing traffic recovery has happened without the return of Chinese tourists with capacity into and out of China still significantly below 2019. This gives us confidence of ongoing solid traffic trends through the end of 2023 and into 2024, despite the economic overhang.

Return of Asian travellers will support airport earnings

Most impressive is that the recovery to date has been with limited contribution from Asian passengers. While much attention has been placed on China’s reopening, it hasn’t yet translated into a material increase in Chinese traffic due to lengthy visa and passport processing times, and lower airline capacity.

To put some numbers to it, ADP stated that in Q1 of this year, Chinese passengers were at just 10% of the level reported in Q1 2019. Regarding airline capacity, it was highlighted that some airlines have been slow to ramp up capacity as profitability on Chinese flights has reduced due to the ban on Russian airspace. For ADP, at the end of June, the number of flights to China were at just 27 per week, compared to 95 a week pre COVID.

However, there is confidence in the return of the Chinese traveller. Fraport highlighted that there had been a steady recovery since re-opening from 18% of pre-pandemic levels in January, to 52% in June, with expectations this will continue to ramp up in the second half of the year. They have left their outlook unchanged for the financial year, anticipating Q3 will be back to 50-60% of 2019 while Q4 is expected to reach 80%, with December at 90%.

This is not just a volume story. Chinese passengers tend to be among the highest travel spenders globally. In Paris airports, Chinese passengers only account for 2% of passengers, but have an outsized impact on SPP (spend per pax) of almost 15%. In the absence of a slowdown in existing passenger mix, the ongoing normalisation of Chinese and Asian traffic will provide a kicker to earnings, and provide a buffer if/when a broader slowdown takes hold.

Utilities

Utilities were at the forefront of most investors’ minds in 2022 due to the energy crisis brought on by the Russia-Ukraine conflict. With Europe having navigated through the winter and with a normalisation in power prices, there was a notable shift in company outlooks.

Energy security and crisis

Interestingly, the term ‘crisis’ was seldom used in our discussions, but operators were very clear that Europe is not out of the woods just yet. While Europe was quick to pivot away from Russian gas, they were lucky due to the mild 2022 winter and increased LNG availability from reduced Asian demand (China remained in lockdown for nearly all of 2022). If these factors were to change this year, alongside any unpredictable moves from Russia (such as putting Russian flows to zero), or further adverse changes in existing European supply / production, then the coming winter could be problematic. This could see an upward reversal in gas prices and, subsequently, power prices, which would impact European energy consumers and economies.

Importantly, at the time of drafting this article, the European Commission announced that Europe’s gas storage levels have hit the 90% target set to be achieved by 1 November, providing some safety net ahead of the upcoming winter. They also highlighted ongoing efforts to diversify the supply of energy in the near and long term.

Hydrogen

Hydrogen, and in particular green hydrogen, has become a bit of a buzz word in the energy sector over the past few years, and was again a key discussion topic with sector participants. What remained clear was that while it’s widely believed that hydrogen will have an important role in the energy transition, viability for serious investment is still at least five years away. Before committing significant capital, operators need to see a cohesive framework and a lowering of the cost curve. Interestingly, we heard more talk around biomethane and other green gases over hydrogen in the shorter term. 

The CFO of Snam stated that while their network could be hydrogen ready very quickly, it is not viable at these levels and is still five plus years away, with pilot projects at the moment in biomethane and CCS.

Diversified infrastructure

Traffic resilient despite high inflation

European toll road traffic has remained resilient despite economic challenges. So far inflation and high rates have resulted in minimal, if any, demand reduction. A continued economic downturn is likely to have a greater impact on heavy versus light vehicles, as truck traffic is more strongly correlated with GDP. Meanwhile, light vehicle traffic is more resilient in a downturn and could potentially increase. Operators highlighted that if people are forced to spend less on travel, a driving holiday becomes more attractive for a typical family relative to more expensive train and air travel. This clearly benefits the road operators Vinci and Eiffage, as well as Getlink, over the summer period.