Why European equities are attractively valued

Investing in European Equities post global financial crisis (GFC) has been particularly challenging, hampered by subdued returns and regular bouts of political volatility. This questions why bother with the asset class?

The pessimism associated with European equities has led to very depressed valuations and this is a good starting point. History suggests it would only take a small positive shift in expectations for an outsized share price performance to be potentially realised.

The key question is what might drive that shift in expectations to help close the European equity market’s current valuation discount to other regional equity and fixed interest markets?

Investor perception in Europe driven by post GFC banking sector experience

We believe a lot of investor perception around the European equity markets is driven by the experience of the past 15 years when growth has been limited.  We would flag, however, that 70% of that was due to earnings contraction from just one sector, banks. 

Post the GFC, the banks came under significant regulatory pressure to bolster their balance sheets, which they did by raising capital via rights issues, technically diluting earnings per share.

The further knock-on effect of the required deleveraging of the banking system meant that the banks could not lend to corporates and support growth.

But today the banking sector is very different and well capitalised

Today the landscape is very different. The banks are extremely well capitalised, enabling them to pay handsome dividends and undertake significant share buybacks. More than this, however, they are also well placed to provide loans and to support growth across Europe.

This is a starkly different story to that of the past decade not only for the banking sector, which should deliver positive earnings rather than earnings detraction, but also for the wider region and equities as a whole. 

There are other signs that we’ve moved away from low growth/low inflation/virtually zero rates of the post GFC too. Covid unleashed fiscal stimulus, in stark contrast to the austerity era post 2008.

Monetary and fiscal policy are both likely to be much more balanced going forward. Europe needs to continue to invest in digitalisation, decarbonisation and near shoring to remain competitive in the ever-changing global economy, building on the European Recovery Fund.

Defence will remain a key focus, too. All of this should be beneficial for growth which in turn will support inflation and so necessitate moderate interest rates (I would say normalised!) - a backdrop that is beneficial for fundamental stock picking.  This will be a completely different regime to that of the past 15 years and so new for many investors. 

Where do you see the risks in European equities?

European equity markets are currently experiencing the uncertainty and bumpy ride that often accompanies the transition from one regime to another.  Whilst we’re confident that the long-term outlook for Europe is underwritten by structural improvements, shorter-term there are cyclical headwinds.

This year GDP growth has been reasonable, but economic momentum has slowed recently. Perhaps this is unsurprising given the “cost of living crisis” and “manufacturing recession,” – both of which have been significant headwinds to overcome.

However, we believe that the worst of these are behind us, as proven by inventories bottoming across much of manufacturing, the strength of corporate balance sheets and, at the consumer level, the high level of household savings plus real wage growth. 

As confidence returns, we would expect economic activity to pick up.  It’s also worth remembering that the eurozone is one of the most rate-sensitive regions, with 50 basis points of cuts already in place and likely more to come.  Stimulus in China should also help because it would support manufacturing.  So, we expect better days ahead, although getting there may not be an overnight process.

Where do you see the main opportunities in Europe?

As all this suggests, the European equities outlook is not a simple one-horse race – there are nuances at both the sector and stock level and investors cannot rely on a simple growth, value or any other single factor approach.  

Also, we need to be conscious of the fading near-term cyclical headwinds versus positive longer-term outlook. We believe that our experienced, fundamental stock picking philosophy with a focus on quality transition, in other words companies changing for the better, is very well suited to this more complex investing environment. 

Accordingly, our strategies benefit from balance and diversification across all the portfolios. Outside of banks, which we discussed in detail above, there are many other opportunities on attractive valuations that are well placed to see earnings grow.

In aerospace & defence, there are those names that should directly benefit from increased government expenditure. In energy, we find companies where an increasingly disciplined approach to capital is driving attractive dividends and share buybacks.

There are also utility companies that are taking advantage of the need for greater electrification and better networks. Plus, renewables are well positioned to benefit from decarbonisation and the structural growth therein.

Europe has some of the leading technology companies in the semi-conductor space which will play a key role in all the secular themes already mentioned. And finally, to flag specifically there is pharma which offers a more defensive positioning for those risk-off days and where R&D upside potential is often over-looked by the markets, in our view. 

What is clear, is that there are many attractively valued opportunities across European equity markets where there is the potential for both structural advantage and idiosyncratic improvements in returns. 

A more normalised interest rate backdrop, similar to that pre-GFC, will enable fundamental stock pickers like us to take advantage of these and to deliver potentially superior returns for investors.