Earlier this year, everything seemed to be running well in Europe. Mario Draghi had promised to “do everything necessary,” growth was returning to the economies of the euro zone, albeit slowly; and even peripheral countries showed recovery. Investors trusted this recovery and returned to the European market, and nobody would bank on the collapse of the euro.

But sentiment has now changed. Has it all been an illusion? Ann Steele, Portfolio Manager for Threadneedle’s Pan-European Equity Strategy, spoke to Funds Society on the problems besetting Europe. Her diagnosis is severe: “We’re in the same spot we were two years ago.” Steele puts some hard data on the table: “Earlier this year, the consensus estimated growth of 14%, in European earnings per share, we are now at 5%, and virtually everything is due to the currency effect. If we look at GDP, we see that growth has stalled. In fact, France does not grow, Germany’s growth is very weak, and Italy has negative growth. These three countries together generate two thirds of GDP in the Euro zone, the situation, therefore, is complicated.”

Economic sanctions on Russia, which even in the best of cases, will remain in force for some time, are affecting quite a few economies. The specter of deflation joins this economic stagnation. The Eurozone’s annual inflation data is, at 0.3%, “light years below the ECB’s 2% objective.” The falling oil prices will not help generate inflation in Europe. In short, “the banking and sovereign debt crisis has led to a growth crisis in Europe,” says Steele.

Some countries have taken bitter, but effective, measures. Steele cites Ireland’s example, which following the necessary reforms has managed to lower its unemployment rate from 15% to 11%, enjoys a recovery of 24% in housing prices, and has achieved 7.7%. GDP growth in the second quarter “The banks were recapitalized in 2009 and have taken off, and a tax reform, which has lowered corporate tax to 12.5%, has attracted worldwide multinationals to Ireland.” The country has managed to lower its budget deficit from 13.7% in 2009 to 2.8% in 2014.

Steele is disappointed that the Irish example does not abound in Europe. Even its island neighbor, the United Kingdom, which has maintained a fairly healthy rate of growth in recent years, is now slowed by political motives. “First we had the Scottish referendum, which will continue to generate debate and change.” Soon, the country faces a general election in 2015, and later, the referendum for the UK‘s permanence inthe EU, scheduled for 2017-18. “As a result, we have a market influenced by politics over the next couple of years,” states the Portfolio Manager, also adding that “we will not see any tax increases in the UK in April, as stated in the consensus, since elections are in May, so, at the earliest,they’ll come towards the end of the first semester.”

Europe faces a difficult road ahead, in which Draghi’s discourse and actions will have to demonstrate their effectiveness. While the European market’s valuation is relatively more attractive than that of the US, it doesn’t stand out in relation to either Japan or the emerging markets. What is the positioning for this market environment, of the pan-European strategy which Ann Steele manages.

It’s in times like these that good stockpicking shows its full potential. The portfolio manager has made several changes to her portfolio, which currently has 60 securities. On one hand, she has tended to invest more in large caps, or even in mega caps, dropping weight in small and mid cap which weigh heavily in domestic markets. By sector, Steele’s ideas for getting the best out of the current situation are:

• Huge commitment onthe European pharmaceutical sector: among the 10 companies with the largest weight in the portfolio, four are pharmaceutical. “On one hand I am overweight in the sector because it has a defensive nature, but mostly because the portfolio of products under development in the field of cancer control is awesome right now, with a range of very encouraging products which act by boosting the immune system so that therapies to fight tumors could change radically. Roche and Novartis have good franchises in such drugs.”
• Sale of domestic banks in which she invested in 2013: Currently, her strategy is underweight on banks, but it has not always been so. Just over a year ago Steele banked on the recovery of European domestic markets and was overweight on domestic medium-sized banks in countries like Spain, Italy and Ireland buying names like Bankinter, Banco Popular and Bank of Ireland. “On seeing the results of some of these banks during the first quarter of 2014, I undid many of these positions, and am now underweight in the sector, and I don’t have any German or French banks in the portfolio,” she explains.
• Success stories such as Pandora and Richemont:  Steele is underweight in consumer defensives “because of its high correlation with the development of emerging markets” and overweight in consumer cyclicals. However, she points out that in this field, the big companies of luxury goods are having uneven behavior. For example, LVMH, which is not in the portfolio, has performed weakly in the alcoholic beverages sector, while it did well in jewelry and watches. “To capitalize on this trend, I have the Swiss luxury goods company, Richemont, in the portfolio; it specializes in fine jewelry and watches, and also has a net cash position of 4.7 billion Euros.” Another success story which forms part of Steele’s portfolio is the Danish jewelry company Pandora, which has experienced a change in its management team to become a major exporter globally, and now plans to enter the Chinese market.

“Now, the strategy has a lower beta than a year ago, as well as a lower tracking error, and 3.5% in cash, more than usual. I see value in the European market, but also problems of growth, both political and geopolitical, so it’s a good time to step aside and wait,” says Ann Steele, portfolio manager for Threadneedle’s strategy for Pan-European Equities.