Who are the likely winners and losers?
In combination, I expect these drivers to have a significant impact on European financial assets, which are starting to benefit from increased investor interest. In European equity markets, I anticipate a rotation away from companies that benefited the most from globalisation and lower interest rates to select value stocks such as banks and telecoms, defence stocks, small caps and enablers of the energy transition that are protected by high barriers to entry.
However, I do not expect this rotation to be a uniform or smooth process, suggesting the need for rigorous risk management and careful stock selection based on an in-depth analysis of the precise impact of this regime at both sector and stock level.
How far can Europe’s rerating go?
European equities have seen a marginal rerating since the beginning of the year from unusually depressed levels and valuations are now broadly in line with their 30-year norm. The rerating relative to the US equity market has been slightly more significant on a sector-adjusted basis, but Europe continues to trade more than one standard deviation below the norm versus the US market. I believe the rerating is justified as valuations at the end of 2024 — at levels last seen during the euro crisis — were clearly too low, given improving financial conditions, strong consumer balance sheets and an improving construction sector. More recently, valuations increased further on the back of the German fiscal announcement.
Looking ahead, we may see some pullback as investor sentiment stabilises, with certain sectors such as defence potentially overbought. However, I think the structural case for Europe remains robust. There is clearly some uncertainty about how successful the German fiscal package will be over the long term, but it has real potential to put German and European growth on an improving trajectory. Likewise, our global industry analysts believe that the European defence sector and associated industrials still offer ample opportunity for long-term growth as Europe is seeking to both shore up its defences and reduce its dependence on the US. However, that build-out will take time to materialise given constraints in manpower, expertise and materials supply.
At present, I see the greatest scope for rerating in the value segment of the market as, according to DataStream data, European value stocks still trade one standard deviation below their norm on an absolute 12-month forward P/E basis. There are, of course, good reasons why some European value sectors are cheap — for instance, European autos — but I still think that European value offers investors the biggest stock-picking opportunity set in this new European regime.
Equity Market Outlook
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By
Andrew Heiskell
Nicolas Wylenzek