Why Everyone’s Talking About… European Equities

European companies have often been considered only grudgingly by investors. Away from the glitz and glamour of the US, the relative security of the UK or even the thrill ride of Latin America, Europe’s stock offerings have often fallen somewhere in between, with any allocations considered more of a nod to the benchmark than indicative of any overwhelming desire to invest.

But in recent years, this has begun to change. European companies have become more outward facing, repositioning themselves as facilitators of the global economy.

Recent research¹ suggests that circa 60% of European company sales are generated outside of the bloc, double that of their US counterparts. Even in the context of an increased push towards deglobalisation, the continent hosts industry leaders in fields such as aerospace, healthcare and semiconductors, many of which provide the building blocks necessary to reroute supply chains away from the traditional pan-Asian routes.

The bloc does, however, have its own set of headwinds to contend with. For example, the war in Ukraine has had a disproportionate impact on European equities due to the region’s reliance on energy and commodities from Russia. Likewise, Europe’s reliance on China in sectors like luxury goods has left the continent sensitive to China’s economic malaise.

European stocks have historically been slower to rebound from crises than those in the US, and this remains the case today. That being said, fund managers appear to recognise both the near-term headwinds² and the longer-term potential³ that exists within European equities.

European equities trade at significantly lower valuations than their US equivalents; currently Europe's price-to-earnings ratio is now down to just 12.5 times versus the US at close to 18 times⁴.

This dislocation became pronounced following the Global Financial Crisis when the tech-heavy US stock market was better able to take advantage of the low-interest rate environment. As the low rates stretched throughout the following decade, the US stock market surged forward on what became a near ten-year bull run, birthing several mega-cap companies such as the FAANGs – Facebook (now Meta), Apple, Amazon, Netflix and Google (now Alphabet).

The US stock market saw a similar boom in the 1970s, when investment surged in the so-called ‘Nifty Fifty’, a set of companies seen as safe investments that investors were happy to pay a premium for against the backdrop of extreme economic uncertainty, much like today’s environment. For the Nifty Fifty, the bear market that followed the boom later in the decade wiped out those large price gains.

The gap in stock market capitalisations between the Europe and the US is now at its highest point since the early 1980s⁵. But the FAANGs – more recently referred to as ‘the magnificent seven’ (Tesla, Apple, Nvidia, Microsoft, Amazon, Meta and Alphabet) – could follow in the Nifty Fifty’s footsteps to narrow the gap. Though the disparity between European and US valuations may be significant, this is far from an inditement on the quality of European companies and may present a more palatable entry point for investors.

Technology stocks represent a far smaller portion of the European equity market, c.7%, compared to c.30% in the US6. With this in mind, it's understandable that European equities have not kept pace with the US in this latest boom in growth stocks, powered by a surge in demand for AI.

However, it is a common misconception that Europe has no tech output. For example, Europe boasts several semiconductor industry manufacturers⁷, most notably ASML, as well as significant players within the healthcare technology sector such as Novo Nordisk, which surged earlier this year on the release of its weight loss drug Wegovy.

Investor confidence in the US took a knock earlier this year in the wake of a series of bank collapses, most famously that of Silicon Valley Bank, which European financial regulators deemed the US authorities to have handled poorly⁸.

By contrast, the protracted demise of Credit Suisse in Europe was handled far more efficiently, with the Swiss government brokering a deal with rival bank UBS to secure positive outcomes for Credit Suisse clients and the banking sector at large. This is part of a broader push from the European Central Bank to support sovereign credit markets, which also includes the purchasing of assets, if required, during periods of market distress.

Europe fell into a technical recession earlier this year when GDP fell by 0.1% in Q19⁹, marking the second consecutive quarter of slippage.

In the short-term, the focus of the European Central Bank remains fixed on fending off inflation, which it has been combatting by raising interest rates to an all-time high¹⁰.

Economic growth has suffered as a consequence, but with the bloc’s monetary tightening cycle fast approaching its apex, there is a widespread expectation that growth may resume once the pressure of higher interest rates is alleviated.

The consensus among financial commentators is that Europe may be set for a period of short-term pain but has a more prosperous long-term outlook.

The IMF forecasts growth of 0.7% for 2023 as a whole in advanced Europe, down from 3.6% in the post-pandemic rebound of 2022. It predicts the outlook will improve gradually, with growth in 2024 rising to 1.2% in advanced and 2.9% in European emerging market economies (excluding Belarus, Russia, Turkey and Ukraine)¹¹.

The European Central Bank predicts the path for inflation, excluding energy and food, to average 5.1% in 2023, 2.9% in 2024 and 2.2% in 2025¹². It forecasts slower economic growth for the continent in the coming months as it continues to rebuild following the challenges of 2022. This was reflected in Bank of America’s latest European Fund Manager survey, in which 89% of respondents felt that growth would be negatively impacted by continued rises in interest rates¹³.

However, the European equity market boasts many quality companies that are well-positioned to prosper once the economic environment brightens. The disparity between the price-to-earnings ratios in Europe and the US suggests that European companies may be undervalued and present an opportunity for investors seeking equity exposure away from the premium prices of the US market.

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GLOSSARY

Benchmark - A standard with which to measure performance. It is often an index of investment instruments against which portfolio performance is evaluated. One of the most popular benchmarks for equities is the S&P 500, which lists roughly 500 companies based on specific metrics and valuation techniques that reflect the best-performing stocks on the stock market (according to the professionals at Standard & Poor's, who created it).
Earnings per share (EPS) - A key measure of corporate profitability and is commonly used to price stocks, EPS is the portion of a company's income available to shareholders and allocated to each outstanding share of common stock. It is measured as the difference between net income and preferred dividends, divided by the average number of outstanding common shares.
Price-to-earnings ratios (P/E ratio) - Used for valuing companies and to find out whether they are overvalued or undervalued. It is calculated by dividing the market value price per share by the company's earnings per share. A high P/E ratio can mean that a stock's price is high relative to earnings and possibly overvalued. A low P/E ratio might indicate that the current stock price is low relative to earnings.

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Why Everyone’s Talking About… European Equities