- Macro Strategist
United States, Institutional
Change
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Key points
- Sentiment around European equities is clearly challenged, but I see positive potential for active investors on both a short- and long-term basis as Europe’s economies move towards recovery.
- Where to find the near-term opportunities will, in my view, largely depend on five factors that I’m monitoring closely.
- Longer term, I believe European markets are undergoing a paradigm shift. The associated divergence and volatility may create significant new opportunities for active investors.
With the continued focus on the “Magnificent Seven” and the technology sector more broadly, I think it is easy to overlook the potential of European equities beyond the so-called “GRANOLAS”, 11 leading companies that have accounted for most of the recent European equity market gains. While European benchmark indices lagged their US counterparts in 2023, European equities outperformed all major markets on an equally weighted basis. Despite remaining under pressure, in my view, the backdrop for European equities is increasingly attractive for active investors on both a short- and long-term basis.
Approaching a positive inflection point
European economic momentum is in the process of inflecting higher. This may seem counterintuitive as the region’s economic performance remains underwhelming. Notably, Germany — Europe’s powerhouse — is still struggling to adapt to a new structural environment. At the same time, European earnings are coming under pressure as inflation normalises. However, leading economic indicators across much of Europe are clearly rebounding and valuations are reflecting the risk to earnings. I would be cautious of areas where margins might have been artificially expanded on the back of strong nominal growth (the main driver of earnings) but I like European companies and sectors with resilient earnings and positive earnings revisions (e.g., health care).
Over the short and medium term, I think that the performance of European equities will, to a large degree, depend on five factors that I am monitoring closely:
- Growth momentum — Positive real wage growth, easing financial conditions and a supportive fiscal backdrop are all likely to contribute to an uptick in European growth. By comparison, I consider the upside for the US to be more limited despite recent strong data. This environment should benefit more cycle-dependent, domestic/regional areas of the market such as travel and leisure stocks and small caps. It could also help domestic banks offset the likely drop in net interest margins from their current peaks.
- Earnings resilience — Strong nominal growth and margin resilience were major tailwinds for earnings in 2022 and 2023. As inflation slows, these drivers are likely to reverse direction and curb earnings growth in 2024. Companies are also having to contend with rising interest-rate expenses. Consensus earnings growth estimates are more muted than in the US and Japan, but I am still concerned about downside risk, with further downward earnings revisions likely. Medium term, however, the likelihood of positive surprises may increase as Europe’s economies regain traction.
- China — Europe has several companies — notably in the luxury, automotive and mining sectors — that offer indirect exposure to China at a (partially) low cost and without the idiosyncratic risks associated with Chinese stocks.
- Importance of key themes — In my opinion, AI and the energy transition will be the major growth themes driving equity returns over the coming years. Currently, European equities offer significant exposure to the energy transition but less so to AI. Valuations have consequently suffered from the recent focus on AI. A partial reversal of that trend in favour of the energy transition would be a key tailwind for many European names. While the recent pushback in European politics against some of the proposed climate policies may delay such a reversal, the structural case underpinning the energy transition remains largely intact.
- Valuations — Europe’s still very attractive valuations suggest a lot of negative news is already priced in. However, I do not view this as a catalyst for future outperformance.
Targeting near-term areas of potential
While it is my conviction that opportunities will be mainly found at a company level, the following perspectives can help with portfolio positioning:
- At a country level, I consider peripheral economies such as Spain and Italy to be more attractive than core countries as they are more geared towards domestic, consumer-led growth, benefit proportionally more from the European Union’s NextGenerationEU initiative and have greater access to cheaper energy.
- From a sector perspective, I favour domestic cyclicality, which, in my opinion, can be best captured through banks with diversified exposure to European markets, a few selective domestic plays, such as travel and leisure, and European small caps.
- From a factor angle, I think earnings resilience and domestic exposure are two areas that should do well.
Mitigating downside risk
The two key risks I’m focusing on are a slowdown in the global cycle and a surge in geopolitical tensions. If markets started to worry again about the potential of a US recession, European equities would struggle to do well in light of their cyclicality. Increased geopolitical tensions would also be detrimental given Europe’s open economy, dependence on energy imports and large export exposure to China.
I see potential to mitigate some of these near-term risks through allocations to European defensives, including utilities, telecoms and health care. By contrast, I would largely avoid consumer and industrial cyclicals, which are already pricing in a sharp recovery given their rally at the end of 2023.
Taking a more structural perspective
I believe European and global markets are currently going through a paradigm shift as we enter a world of structurally higher inflation and higher rates amid deglobalisation, growing geopolitical rivalry, changing demographics and climate change. In turn, these developments are leading to increased political intervention and an emphasis on national security and resilience, onshoring and greater fiscal spending. For investors, this may mean that:
- Valuations matter increasingly — With money no longer “free”, investors will not buy growth- and long-duration assets at any price.
- International exposure is less of a clear advantage — Companies and economies with high international exposure have benefited significantly from globalisation over the last few decades. With that trend now reversing, domestic sectors and Europe’s peripheral economies stand to gain.
- New leaders will emerge — The bursting of the internet bubble in 2000 and the global financial crisis in 2008 resulted in a change of leadership within European equity markets. The current structural transition may trigger another change.
I believe that each of these developments is likely to create more divergence and volatility. I think active investors will be well placed to exploit the associated investment opportunities, provided they are able to combine fundamental company research insights with an accurate understanding of the relevant sector, country and macro dynamics.
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