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A sharp fall in gas prices, China’s reopening and slowing inflation meant European equities not only rose in absolute terms but also significantly outperformed US equities over the last six months. The path forward, however, remains uncertain, suggesting investors need to tread carefully and be selective.
European equities are structurally very cyclical and global markets face a range of cyclical headwinds:
However, I expect European equities to outperform the US over the next three to six months. European equities experienced a period of record outflows throughout 2021, suggesting investors are very cautiously positioned. Moreover, there are several factors that could mitigate and delay the slowdown in growth. These include the persistence of an elevated volume of order backlogs, households continuing to sit on excess savings, the labour market remaining tight and a boost to growth from China’s reopening. Lastly, depressed valuations suggest European equities are already pricing for a fall in earnings.
I remain cautious on consumer and industrial cyclicals, outside of energy-transition plays, because I think they are pricing for an economic recovery that seems too optimistic. In contrast, European small caps offer a more attractive risk/reward outlook. They don’t appear to be priced for a sharp economic recovery and could benefit from the recent strength in the euro. In my view, the European banking sector is also attractively valued and should be able to deliver better earnings momentum than the market, despite the slowdown. Lastly, I think defensive areas within the European growth segment of the market (software, for example) offer potentially attractive upside after they underperformed on the back of higher interest rates.
Over the longer term (18+ months), the outlook for European equities appears structurally much better for three key reasons:
These three reasons suggest that European equity markets are unlikely to experience a repeat of the structural underperformance of the last decade.
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