Is now the time for Europe?

Very rarely in the past decade have European equities outperformed their US peers for long. With the bloc’s outlook seemingly improving, many expect European indices to regain their leadership. While there is good reason for this, the region remains a stockpickers market.

Sunnier prospects

For once, Europe’s outlook appears relatively bright relative to the US. First, the region seems to be handling the COVID-19 pandemic better. While initially strict containment measures crippled economic activity for a short period, the area has seen a much stronger rebound once the worst of the health crisis passed.

On the other hand, the US’s laxer containment approach has left the country battling with the disease for much longer, causing worse economic damage. Additionally, Europe showed that once again, in time of crisis, it can unite. Indeed, the creation of the EU Recovery Fund last month appears a pivotal move towards much-needed further integration in the region.

Finally, while Europe has often seemed disjointed and the epicentre of political uncertainty, by contrast this year all eyes are on the US and what looks likely be a contested presidential election in November.

A recovery play

While Europe appears well positioned economically speaking, investing in equities isn’t just about domestic growth prospects. It tends to be far more about sector composition and prospects for companies’ profits. As such, the region’s potential to outperform is often more closely linked to changing trends in growth versus value styles of investing rather than its domestic growth momentum.

Indeed, at the index level, European equities exhibit a strong value tilt driven by relatively large weightings to sectors such as financials (15% of the Stoxx Europe 600 Index compared with 10% for the S&P 500), energy (4% versus 2.6%) and autos (2% against 0.3%). On the other hand, growth sectors, particularly technology, are underrepresented (7.9% vs 27.5%). For this reason, European indices tend to produce their best relative performance during recoveries, whether in growth or investor sentiment.

In the last fifteen years European equities significantly outperformed the US during 2009, following the global recession, and in the first half of 2017, after troubles caused by the constitutional referendum in Italy.

This is not a rerun of 2008

Arguably, prospects this time seem akin to the post-2008 recovery. If so, this should bode well for European indices. While there is merit in this view, the challenges faced by the bloc’s “value” sectors are somewhat different and potentially more damaging.

Unlike fifteen years ago, European banks face negative interest rates, much tougher regulations and strong competition from fintech players. Similarly, this time round the auto sector is trying to adjust to the surging demand for less polluting cars while energy grapples with low oil prices and far more investor focus in improved environmental, social and governance compliance.

Opportunities lie with companies

The new challenges being faced by European companies could easily transform what might appear to be a value play into a “value trap” that causes European indices to underperform their global peers. This is why US indices seem to offer better prospects over the medium term. Yet, there is still likely to be merit in investing in Europe.

Indeed, Europe is home to world-leading companies. These can be found in sectors like technology, industrials, healthcare and even consumer discretionary with companies targeting the luxury market for example. And while many may not have much influence in the Stoxx Europe 600 index, the S&P 500 or the Nasdaq, they still have appeal.

Be active

While there may be a window of opportunity for Europe to outperform, we believe this should be seen as a short-term trade rather than as a long-term investment. Unfortunately, for those wanting to increase European equity allocations, the way the bloc’s indices are constructed can make them relatively less attractive to long-term investors. As such, active management seems to be the key to unlocking value when committing capital to the region.

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