Why European equities are attractively valued

Why European equities are attractively valued

We believe European equities are trading at attractive valuations compared to other regional equity and fixed interest markets. 

Concerns about the global cycle, energy costs and wider inflation plus the Ukraine War have weighed heavily on European equity flows leaving European equities attractively valued. This is potentially a very good starting point for shareholder returns. 

Although in 2023 economic data confirmed a minor technical recession, European corporate balance sheets are strong and in our European strategy, companies have very low levels of or even zero debt. 

This is key given weak balance sheets in slowdowns can lead to distressed share issuance. This is what happened in the banking sector post Global Financial Crisis (GFC), for example. If balance sheets are, as today, strong, this risk is low.

Sticking with banks, today they are not only well capitalised, but also capital generation is benefitting from higher interest rates allowing them to pay handsome dividends and undertake significant share buybacks. This is a starkly different story to that of the past decade. 

We also believe that interest rates will be ‘higher for longer’ – more on that later – which makes the long-term investment case for banks all the more compelling.

Where do you see the risks in European equities?

The focus is on recession and the type of recessionary landing ahead – hard or soft – plus where interest rates are likely to go.  Both issues will have an impact on all markets, not just European equities. 

Addressing the recessionary concerns first, European macro data and company reports have shown manufacturing has been hit hardest by recent economic weakness including severe cyclical destocking. But the services and consumer side have been far more resilient helped by high employment, wage growth, strong savings and pent-up demand. 

This division in the economy has been reflected in share prices with upstream companies, such as manufacturing, experiencing cuts to earnings and valuations de-rating accordingly – in some instances, hits to numbers have been larger than those seen in 2009.  Meanwhile, services companies in consumer-facing areas earnings have remained strong; valuation metrics are still quite high relative to history. 

Should we experience a ‘soft’ landing, then we would expect those manufacturing, upstream areas to rebound, both operationally and so in terms of valuations – they were the first into the recession and we believe they will be first out in this scenario.  In a ‘hard’ landing scenario, we think the downside to the cyclical parts of the market will be more limited, given the extreme cuts already forecast. Conversely for the services and consumer-exposed end, the downside and valuation risk would be significant.Across our European strategy, our cyclical exposure is more towards manufacturing and industrials and we’re avoiding those consumer-facing and services names where there are both cyclical and valuation risk.

Returning to interest rates, we believe that we are unlikely to return to the interest rate lows that we experienced in the decade post the GFC. Unemployment is low, wages are still growing, and inflation remains above trend.  We think the risk is that interest rates will stay higher for longer – the ‘Table Mountain’ versus ‘Matterhorn’ view. Growth stocks – or long duration names – in sectors such as technology, which have enjoyed the benefits of low interest rates for the past decade or so, using this environment to fund their expansion and support their valuation multiples. This sector may struggle to continue to dominate performance.

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. 

We believe that our experienced, fundamental stock picking philosophy with a focus on quality transition is very well suited to this more complex investing environment.  Our strategies benefit from many different themes. Non-consumer facing, manufacturing and capital-intensive names are intrinsically more appealing as already mentioned, but we also have exposure to large cap pharma where there’s little or nothing in their share prices to reflect the future growth of R&D. 

Energy is also extremely interesting in the current environment with oil prices likely to be supported in the near-term by a shortage of US supply. More significantly, the large integrated energy names are another area where many have extremely low or negligible debt, they are generating huge amounts of free cash flow which they are then returning to shareholders via dividends and share buybacks – the same theme as we see with banks. 

ESG will be a focus for investments

It would be wrong not to mention the energy transition here. Strong balance sheets and free cash flow means plenty of firepower for investing in renewable programmes at potentially high returns. Furthermore, as the ESG community increasingly realises the key role these companies play in global decarbonisation, they will receive greater focus from the investment community, too.

ESG is a huge theme in Europe: Regulations continue to be introduced across the board to support the drive towards net zero and to encourage investment to that end.  Again, this is another key theme across our European strategy. 

In the longer-term in Europe, we believe concerns over the security of energy supply plus the nearshoring of manufacturing and industrials is going to result in significant investment.  Linked to this is continued decarbonisation and regeneration as part of the EU’s drive to remain at the forefront of the net zero agenda, plus broad-based digitalisation to continue efficiency gains.  All of this broad investment will drive employment, support wages and inflation will persist … and so in a nice circularity for our strategies at least, interest rates will remain higher for longer. 

In short, we believe the case for European equities is complex but strong and we are well positioned to continue to benefit.