- Macro Strategist
United States, Institutional
Change
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Since the onset of the global financial crisis (GFC), European equities have been buffeted by headwinds that have led them to persistently underperform their US peers. Now, I think, we are about to see a structural shift. While sections of the market remain vulnerable to temporary underperformance, I believe that European equities are in the best structural position that they have been in for years.
What caused the persistent relative underperformance?
Since 2007, European equities (STOXX 600 Index) have underperformed US equities (S&P 500 Index) by 61% in US-dollar terms (Figure 1).
Figure 1
Earnings growth is the main reason for this underperformance. Since 2007, the total earnings of S&P 500 constituents grew by approximately 120%, compared to only 36% for their European counterparts.
The key factors causing this systematic underperformance include:
- Fiscal austerity — Europe has had to contend with both the GFC and a sovereign debt crisis that threatened the very existence of the euro area. In response, we saw deep cuts in public expenditure across much of Europe, which depressed domestic demand and investment. According to the Institute of International Finance, fiscal tightening in Europe reduced trend GDP growth by more than 10% compared to the US.
- Bank deleveraging — A sharp reduction in bank lending — still the primary source of corporate funding in Europe — curtailed domestic demand and investment further and hampered the effectiveness of easy monetary policy.
- Lack of disruptors — Ultra-loose monetary policy was particularly beneficial for “disruptor” companies, most of which were privately held or US-listed. Access to cheap funding and no legacy costs allowed these companies to disrupt a wide range of sectors across Europe.
- Limited exposure to the technology sector — Europe’s relatively small tech sector meant that it missed out on some of the biggest trends of the last decade, including the move to the cloud, software as a service (SaaS), social media and the Internet of Things.
Why may European equities narrow the gap?
In my opinion, Europe’s long-term outlook has improved meaningfully, and I believe this is due to five important factors:
More fiscal spending — After more than a decade of austerity, the European Union (EU) is using coordinated fiscal spending as a key tool to tackle critical issues such as the energy transition and digitalisation. Key initiatives include:
- the NextGenerationEU recovery plan financed by the issuance of common debt;
- the likely creation of a European Sovereignty Fund to support strategic industries; and
- the relaxation of the fiscal rules governing the euro area.
Positive rates — I see structurally higher interest rates as supportive for European equity markets given the overweight to value stocks, which are typically more resilient to higher rates, and “old sector” incumbent companies. Growth stocks, particularly disruptor companies, have longer cash-flow and profit cycles and are therefore more sensitive to higher rates. Europe has few disruptors but many disrupted companies that can cope better with this new environment. For instance, in the telecommunications sector, we have witnessed revenue growth in the mobile telecoms market for the first time in 15 years as higher debt costs have forced new entrants to increase prices, enabling incumbents to follow suit. At the same time, growth stocks look unusually expensive relative to value stocks globally (Figure 2).
Figure 2
Banks’ improving profitability — Negative rates compressed banks’ net interest margins, but this pain is now receding. Over time, I anticipate higher valuations for European banks as this still important market segment starts to reflect its improved profitability.
Exposure to the next “supercycle” — While Europe was largely left on the sidelines during the tech cycle, European companies are well positioned for the new energy-transition cycle. Credit Suisse has identified 42 companies in Europe, representing around 15% of Europe’s total market capitalization, which it considers leaders in energy transition or sustainability. Moreover, European companies involved in the energy transition stand to benefit from strong fiscal and regulatory support in Europe and the US.
Attractive valuations — While I don’t expect the valuation gap between the US and Europe to close, the four factors above suggest it could narrow significantly. Compared to the US, Europe looks unusually cheap relative to its 10-year norm. This holds true against a wide range of valuation measures, be it sector-adjusted and growth-adjusted price-to-earnings or shareholder yield.
What could derail this more positive longer-term trajectory?
In my view, European equities face three key risks over the longer term:
- An ineffective industrial policy — I anticipate that the restructuring of supply chains, onshoring and the energy transition will be key drivers of industrial policy over the coming decade, with governments around the globe seeking to create more business-friendly environments for a range of strategically important sectors, such as battery technology, renewable energy and artificial intelligence. Europe’s ability to compete is hampered by differing national interests and its complex decision-making process. While I think Europe will ultimately come up with a coherent and impactful strategy, failure could result in accelerated deindustrialisation and weaker domestic demand.
- US/China tensions — Europe remains heavily geared towards global growth and global trade, with both the US and China being major markets for its products and services. A further deterioration in US/China relations could severely hurt the profitability of European companies.
- Sustainability of the euro area — While progress has been made over the last few years, the euro area’s heterogenous structure remains vulnerable during times of economic stress and uncertainty. Markets could return to the question of individual member countries’ debt sustainability, with Italy being a potential trigger given its deteriorating debt metrics. While I think the EU now has the necessary tools to deal with such a fundamental threat, a sharp widening in Italian sovereign bond spreads would still have a major negative impact on European equity markets.
What about the short-term challenges?
In the short term, it is harder to make a constructive call on European equities in a global context. Europe’s international exposure and high number of cyclical companies make it vulnerable to a potential slowdown in the US or a faltering Chinese recovery. The European Central Bank’s most recent bank lending survey already points to deteriorating lending conditions and slower economic momentum.
What are the investment implications?
In the short to medium term, I think it is important to adopt a more defensive stance. I am particularly cautious on European consumer and industrial cyclicals, as they appear to be pricing for an economic recovery that seems too optimistic.
From a structural perspective, I observe a wide range of areas that may benefit from the five key trends discussed above, but three areas in particular stand out:
- Regulated industries — Banks, utilities and telecoms, which have borne the brunt of tighter regulation, weak domestic demand and constrained fiscal spending, may now be turning a corner. Utilities and telecoms are likely to play a central role in achieving the EU’s strategic goals of energy independence and accelerated digitalisation, while banks stand to gain from the expected acceleration in domestic demand and structurally higher rates.
- Selective industrials exposed to structural tailwinds — European industrials look expensive and vulnerable to a global slowdown, but I believe that industrials with significant exposure to the energy transition and digitalisation could be significant winners over the long run, given regulatory and fiscal tailwinds.
- Domestic exposure via small caps — European small-cap stocks tend to be domestically focused — typically outperforming when the euro strengthens — and while they are cyclical, current valuations suggest any near-term slowdown is already priced in.
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Andrew Heiskell
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