Is it time to consider investing in Europe?

The European stock market has spent the last decade feeling unloved and cast out into the shadows of US exceptionalism, thanks to the US’s dominance in the tech-sector and flourishing economy. But with the US markets now looking rather expensive, could it be the time to favour European shares?

Europe’s economic outlook – showing signs of bottoming

• Europe’s economy has had a tough time in recent years with growth stagnating and geopolitical tensions. The European manufacturing sector has struggled, driven by weakness within the German industrial sector which has historically been a key engine for growth in the region.
• On the other hand, the services sector has been strong, which is to be expected during the warmer months and the seasonal nature of tourism. But the southern parts of the regional economy have been performing better on a relative basis for some time. With green shoots appearing in the manufacturing sector and services continuing to remain strong, regional growth is expected to inflect higher towards trend levels by the end of this year.
• Inflation in the euro area has fallen from 10.6% to 2.4% and expectations are now placing inflation to remain around the target level of 2% in the near term. The euro zone has different inflation dynamics to other countries, like the US and UK, which means it should be able to avoid a ‘higher for longer’ scenario.
• A more benign inflation outlook should allow the European Central Bank (ECB) to cut rates against a backdrop of bottoming growth rates. We expect the ECB to be the first major central bank to begin its rate cutting cycle, acting as a tailwind for markets. Lower interest rates will ease the cost of capital for corporates, continuing to improve profit margins, and earnings are expected to grow modestly in 2024.
• Based on the above, we expect the outlook to improve from here and growth to eventually pick up.

The European market – bargains to be had?

European earnings expectations are currently pricing in a contraction over the next 12 months, the lowest growth rate among regional indices and a low hurdle rate. This might not sound too promising on the surface; however, with a negative outlook priced into markets, it creates headroom for positive surprises and provides scope for value opportunities.

It’s important to highlight that the economic outlook for growth isn’t always a bellwether for corporate earnings. According to BlackRock, around 65% of Europe’s listed company earnings are derived from overseas compared with 40% in 2010. So, the economy and stock market do not always act in tandem. We have seen this play out in 2024 so far, with the STOXX Europe 600 index (which is made up of large, mid, and small cap companies across Europe) returning 15% in the last six months.

The European market is well diversified by country and sector – France, Switzerland, Germany, and the Netherlands are the biggest constituents. Given its diversified nature, certain countries and sectors will be shaping up better than others, therefore it’s important to look beneath the bonnet when assessing the potential for the region.

The largest sector in region is financials, which makes up only 17% of the index. And there are six industries represented in the 10 biggest companies. In comparison, ‘the magnificent seven’ tech-related stocks have dominated US market performance recently and now make up more than 25% of the market.

The European equivalent to the magnificent seven is ‘the granolas’, which are GSK, Roche, ASML, Nestlé, Novartis, Novo Nordisk, L’Oreal, LVMH, AstraZeneca, SAP, and Sanofi. They have less dominance at an index level (relative to the magnificent seven), accounting for around 15% of the STOXX Europe 600 index.

European equity valuations are mixed on an absolute basis, but are close to historical levels at the headline index level. Mid and small caps currently sit at more attractive valuation levels on an absolute basis and versus the headline index. Looking on a relative basis, European equities are valued towards historical lows compared to the expensive US stock market.

We have a preference to small and mid-cap stocks given their positive valuations and bottoming earnings growth. These stocks are more domestically focussed, providing more exposure to local economies when compared to large cap stocks, like the granolas, which generate the majority of their revenue from overseas.

Additionally, a backdrop of falling interest rates and the reduced cost of capital will be greater for smaller companies given Europe’s reliance on bank loans that are predominately on a floating rate. We expect this to boost earnings alongside positive demand impacts.

The 12-month price-to-earnings (P/E) ratio when comparing small cap vs large cap is its lowest in a decade and has dropped considerably since 2020.

For the reasons mentioned above, we think there are pockets of opportunities across Europe. At our previous asset allocation meeting in April, we moved from underweight to neutral for the region from a dynamic asset allocation standpoint.