Hunting for value in European equities

• Many investors considered European equities as a perfect “value” trade earlier this year, but they now lag their US peers
• While European stocks delivered significant upside in the first half of the year, in our view the eurozone’s longer-term outlook looks unappealing – with rising debt levels and growth that’s highly dependent on China and elsewhere
• But Europe shouldn’t be dismissed by investors. It can still be an attractive hunting ground for those willing to focus on sector or stock-specific opportunities
• It’s why we believe active management continues to be key in the region – focusing on luxury, industrials and healthcare stocks.

With European equities underperforming US peers again and the pace of the recovery in doubt as COVID-19 infection levels rise, are opportunities emerging for investors in the region?

Continental European equities were seen as the perfect “value” trade, set to outperform in an economic reopening and recovery scenario, by an ever increasing proportion of investors earlier this year. While we were sympathetic to this rationale, we’ve always thought that any outperformance would be short-lived. Fast forward to today and eurozone indices are once again lagging their US peers, reinforcing our view that active management is key in the region.

Europe as a value play

European indices remain geared towards cyclical and value sectors such as financials, industrials and certain parts of consumer discretionary such as autos and retail (see chart). This makes them well positioned to profit from accelerating economic activity. And because European companies tend to be more exposed to global trade (the eurozone’s trade-to-gross domestic product stands at 82%, versus 26% in the US, according to the World Bank¹), the eurozone appears to be great global recovery play.

Timing is of the essence

However, as we’ve highlighted before, the post-pandemic rebound in financial markets was likely to be similar to the collapse that occurred in early 2020: violent and short-lived, requiring spot-on timing. This is exactly what happened as, over the first two weeks of November, eurozone indices outperformed their US counterparts by around 6%. After that, stocks in both areas moved in tandem.

More recently, in May and June, eurozone stocks extended their lead slightly over US peers but then lost all of their total outperformance in June and July as concerns over global growth re-emerge. Because timing both the entry and exit points to perfection is near impossible, we suspect most investors did not capitalise on this opportunity and would have been better off maintaining a preference for higher quality and higher growth exposure.

Growth may disappoint

While the late reopening of eurozone economies may hit the growth differential versus the rest of the world in the second half of this year, we remain sceptical of this view. First, we believe that this timing difference, in terms of peak growth, is well understood and therefore largely priced in markets. Second, with COVID-19 cases on the rise, economic activity may not rebound as strongly as expected.

Finally, Europe’s growth is highly dependent on the rest of the world and on Chinese demand in particular. Economic momentum in China has slowed in the last few months and is likely to translate into lower demand for European exports.

Structural challenges remain

Beyond pandemic-related considerations, the eurozone’s long-term outlook remains unappealing in our view. Through the crisis, the debt load on economies has increased meaningfully with total non-financial debt approaching 300% of the region’s output, albeit with divergences at the country level (see chart). This burden may dampen growth, in particular for companies as interest expenses on the debt may continue to consume much free cash flow.

At the same time, innovation remains hampered by heavy regulation and the overall return on equity generated by European companies continues to trail US peers. Finally, with twenty-eight different members, political gridlocks and risk surrounding national elections are a regular occurrence in the region, creating additional sources of uncertainty for investors.

Reasons not to dismiss Europe

While European equities may be best suited for opportunistic trading-oriented investors, they should not be completely dismissed by those with a longer investment horizon. Indeed, for those willing to focus on sector or stock-specific opportunities, the euro area seems an attractive hunting ground: so far this year about half of the MSCI Euro index components have delivered a performance equal or superior to that of the S&P 500.

In addition, while Europe lags in term of growth exposure, given the limited number of listed tech companies, the region is a clear leader with respect to environmental, social and governance (ESG) matters.

Where to focus

In European equities, similar to the US, we believe that investors should focus on higher quality companies offering strong balance sheets, pricing power and good earnings visibility.

With the technology sector being a small universe in the region, companies exhibiting these characteristics are most frequently found in industries such as luxury, industrials (software-driven or linked to the energy transition) and healthcare. Given valuation levels and the risk around growth in China, the healthcare sector may be better positioned in the short term, in our opinion.