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Europe has had a punishing year. The fallout from the war in Ukraine has caused food and fuel costs to spike, forcing central bankers to move aggressively to curb inflation. Yet, tighter monetary policy is colliding with looser fiscal policy, as governments seek to mitigate the impact of rising costs on household budgets.

The result is a macroeconomic mess, which has pressured stock markets from London and Paris to Berlin and Rome. The FTSE 100, in Britain, is down 4% year to date and down 6% since mid-August; the Stoxx Europe 600, a pan-European index, is off 18%, versus the 21% loss in the S&P 500.

Given the crises Europe has weathered this year, Katrina Dudley, manager of the Franklin Mutual European fund (ticker: TEMIX), is less worried today than she was a year ago. What’s more, she sees glimpses of blue sky behind the clouds, in part because so much bad news is already baked in and some European companies are well positioned for longer-term trends.

Dudley started her career as an accountant, valuing businesses and assets, initially in Sydney. That early training informs her approach as a stockpicker for the value-oriented $688 million Franklin Mutual European fund, whose 8% loss in the past year beat 97% of its peers and whose ability to eke out an average annual 0.93% return over the past five years bested 87% of peers, per Morningstar.

Dudley recently discussed with Barron’s the investment opportunities she’s finding in Europe, and what types of companies may be in for more pain as the economy slows. An edited version of our conversation follows.

Barron’s: How would you describe the economic situation in Europe compared with the U.S.?

Katrina Dudley: We are seeing costs rise much more significantly. For example, the German consumer has seen a 100% increase in electricity and heating bills. That has ramifications for consumer spending. We also see supply-chain issues in Europe, but on a greater scale. Both the Federal Reserve and the European Central Bank are looking to use rate policy to curb inflation, but higher rates could drive us into a recession. Since Europe isn’t coming off such a high-water mark and we have a fully employed economy, any recession is likely to be mild.

Borrowing costs are spiking for debt-laden countries such as Italy. Are you concerned about another financial crisis in Europe?

Many of the concerns have been the result of the rise of populist parties that are nationalistic and more closely aligned with anti–European Union policies and in favor of policies that reduce income gaps.

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We have been positively encouraged by the actions contemplated by European policy makers to lessen the burden of rising energy costs on consumers, especially low-income households. For example, the United Kingdom is capping household energy bills for the next two years. Italy approved a 17 billion euro [$17 billion] package to shield companies and consumers from rising energy costs, Spain cut the value-added tax on electricity, and Germany passed relief packages for households. If the current parties hadn’t acted to assist households most impacted by rising costs, there was a risk of rising populism and rising nationalism.

What is the fallout of the recent financial turmoil in the U.K., which sent the British pound falling to a record low against the dollar?

The market is mainly composed of multinational companies headquartered in the U.K. As a result, the lower pound means overseas earnings translate back to sterling at higher levels. That is a tailwind. But the lower pound also means higher inflation, which is negative for the economy and the consumer, and means rates will need to go higher to contain it.

What are two U.K. holdings?

We own the pharma company GSK [GSK]. The durability of its vaccine business isn’t well appreciated, and the company isn’t getting credit for the turnaround in its pharmaceutical business, while recent concerns around Zantac litigation are being disproportionately reflected in its share price.

Another holding is global real estate services company Savills [SVS.UK], which evolved from a pure broker-based business and pivoted toward less cyclical property and facilities management and investment management.

What else do you want to own in this economic backdrop?

I look at my children—all four would rather give up food than their cellphones. There’s a change in the dynamics of sectors; 20 years ago, food, drink, and tobacco were staples. Tobacco and alcohol are no longer staples. People aren’t smoking as much. But cellphones have become a staple.

What is the best way to invest in that idea?

Deutsche Telekom [DTE.Germany] is German quality with a U.S. cash-flow machine. It is a strong, entrenched German franchise that is well run, with an interest in U.S. mobile operator T-Mobile US [TMUS], and the stock is inexpensive. T-Mobile is investing and taking that short-term pain of restructuring and integrating. That has cash costs associated with it, but once through that, T-Mobile will turn a corner and start seeing cash flowing.

Who else is well positioned to weather the type of recession you see ahead?

We own AerCap Holdings [AER], an aircraft leasing company. It has so much bad news in it that it can’t get much worse. It has already been knocked by Russia, where it had aircraft on lease and the Russians kept the aircraft. Now, there is litigation.

Normally, in a recession we would expect airline travel to decline. That has already happened [due to the Covid pandemic]. A recession is already in AerCap’s numbers: The stock trades at a significant discount—roughly 80% of its book value. AerCap also recently acquired GE Capital Aviation Services, a business that has a lot of upside.

Where in the market is the bad news not already factored in?

The typical playbook when we see demand destruction is that businesses cut back travel and entertainment spending, trade shows, and discretionary spending. But those things have already been curtailed. We are starting to question the number of companies that will be able to generate historical levels of incremental margins because they don’t have the natural cost-savings buffers of the past.

You want to look at cyclical stocks. We are overweight industrials, which have unique characteristics that [make the margin pressure] not an issue.

Can you give an example of such a company?

Alstom [ALO.France], which suffered from working-capital outflows as a result of its acquisition of Bombardier Transportation because it paid suppliers that hadn’t been paid [by Bombardier]. I always like [transactions] where the company has already done the playbook themselves. Alstom has already reduced cash-flow volatility within its own operations, and now it’s taking the same playbook and laying it over Bombardier’s operations.

What happens to demand as Europe goes through a recession?

Alstom is a key beneficiary of political momentum behind the transition to greener technology—for the generation of electricity or, in this case, greener transportation. We see long-term structural drivers that are very much government supported. This is an investment for the long term. Structural drivers are in place, and you are seeing a lot of progress.

Energy stocks have been one of the bright spots in the market. What’s the outlook now for some of the companies you own?

If we look at Shell ’s [energy] transition, it’s probably the most progressive in terms of decarbonization and doing it as it generates strong free cash flow. Higher oil prices mean even stronger free cash flow, and that supports the distribution to shareholders. As value investors, we like that.

Shell [SHEL] knows it has to eventually replace the lost oil-and-gas profits. It is looking at a 20% reduction of carbon intensity by 2030, which we think is very impressive. Versus peers that have focused on transition and are moving into renewables, Shell is taking a different tack. It’s looking at ways of selling electricity, and different ways to address carbon footprint, such as with carbon capture and storage as a service.

You also own a couple of Dutch insurers. What is the draw?

ASR Nederland (ASRNL.Netherlands) was founded in the 1720s. As value investors, cash is key. It has good organic growth and is acquisitive, which we see driving cash generation. It has improving underwriting and is focused on making business more efficient—a key driver of earnings. ASR generates midteens return on equity. The Dutch nonlife insurance market has seen a lot of consolidation, which leads to more rational pricing. We also own NN Group (NN.Netherlands). The market’s focus is on profitability rather than market share.

What does China’s economic slowdown, geopolitical tensions, and coming political leadership transition mean for exporters like Siemens [SIE.Germany]?

It’s a transition. I don’t think it undermines the fact that China has and will continue to be a growth engine. It just may be there’s a one-year pause. From the point of view of Siemens, you aren’t going to stop investing in China, because in the long term there is a positive case and you have been in China for a long period of time. One of Siemens’ competitive advantages is its longevity of commitment to that region. What might be short-term pain, in terms of slowdown, doesn’t undermine the case for economic growth over the long term.

Where do you see the biggest risks in the market?

The risks today are much more identifiable and acknowledged than even a year ago, such as Europe’s energy-security issues. We were wondering when the ECB would raise rates, and that has started in a measured way—[it is] very cognizant of this need to balance raising rates for price stability but not too much to generate a recession. And Covid, which even a year and half ago was a risk, is less so. If you look at the risk profile of Europe versus a year ago, it’s lower. It’s just, at this moment, under a confluence of clouds.

What else could turn out in Europe’s favor?

Even if the euro doesn’t move from here, it will make Europe much more attractive for travel, and that generates economic growth. I think it’s a good setup.

Thanks, Katrina.