It is relatively easy to find reasons why Europe may be a good place to invest in the short term. Valuations are cheap, and the region is experiencing a ‘relief’ rally as the impact from higher energy costs proves less severe than feared. It is also a beneficiary of investor disillusionment with US markets. However, it is also possible to make a case for a longer-term allocation to Europe?
The tide is turning on European stock markets. Having trailed the US equivalent for a decade, in February, the MSCI Europe index was 2.2% ahead of the MSCI All World index, and it is 8% ahead over three months. Some have taken this as a sign that Europe may be on the cusp of stronger run, finally set to outpace the US.
There have been a number of catalysts for this strength. Perhaps the most important is that energy price rises and supply shortages haven’t had the expected economic impact. A mild winter, plus swift action from policymakers, have ensured that manufacturing has been able to continue uninterrupted, with rationing now unlikely. Equally, the impact on consumers has been more muted than expected.
Falling commodity prices have reduced inflationary pressures across the region, which may give the European Central Bank more flexibility on interest rates. Katharine Neiss, chief European economist at PGIM Fixed Income, says: “Our view is the market has likely gone too far in pricing in a succession of rate rises to 4% or higher…On the back of such a punchy outlook for rates, we would not be surprised to see concerns of overtightening resurface, with rate expectations subsequently falling back.”
Equally, valuations still look appealing. The MSCI Europe trades on an average p/e multiple of 12.4x forward earnings, compared to 15.3x for the MSCI All World index. Its average dividend yield is 3.1%, compared to 2.3%. The MSCI Europe index also has a value flavour at a time when investors have fallen out of love with growth stocks.
These factors are all supportive of an overdue bounce in European equities versus their US equivalents. At the same time, the US’s largest stocks are undoubtedly struggling, with the cyclicality of some of the technology giants exposed by the recent economic weakness.
However, Europe’s longer-term problems have not gone away. The region still scores poorly on growth and productivity. The war in Ukraine is still raging on its borders, and the energy crisis is not yet solved. Are there long-term reasons to allocate capital there as well as short-term reasons?
The question revolves around whether there are pockets of structural growth. Certainly, areas such as green energy and digitisation have a strong tailwind. RePower EU and other green initiatives, plus incentives to try and build home grown technology, are directing capital to these areas.
However, the problem is how much investors pay for that growth. In recent years, money has tended to gravitate to quality growth stocks across Europe and particularly those with exposure to these areas. This is particularly true for companies with strong ESG scores, which have been buoyed by the weight of money going into ESG strategies.
Dale Robertson, manager of the Chelverton European Select Fund, says: “Large-cap companies have driven European equity markets for much of the last decade. Undoubtedly, the region does have a lot of good large-cap companies, including L’Oreal, LVMH and ASML. However, all the money has gone into these companies, leaving behind a long tail of small- and mid-cap companies that look undervalued and under-researched.”
ESG-focused investors have chased a handful of large-cap opportunities because they have higher ESG ratings from the rating agencies. This phenomenon has been seen in the dramatic rise and fall of shares such Danish Power Company Orsted.
Robertson says some ESG rating providers disproportionately reward the number of data points rather than the quality of those data points, which naturally disadvantages smaller companies. Again, this means that investors pay a lot for large-cap ‘green’-focused companies and relatively little for their smaller equivalents.
Robertson’s fund is an all-cap strategy, but currently has a 70% allocation to small- and mid-cap companies. He says: “If an investor likes the energy transition theme, they could buy a large-cap utility and will get exposure to a renewable division, but if they want concentrated exposure, they need to move down into the small caps.”
The leaders in areas such as carbon capture, digitalisation and renewable energy technology are small and mid-cap companies. Robertson gives the example of Buvet, which is helping the digitalisation of power grids. “It’s a good example of the type of company you can’t find in large cap.” Recticel focuses on insulation, helping make buildings more efficient. OX2 is a leading European renewable energy group.
Marcel Stotzel, manager of the Fidelity European trust, says investors need to be wary of certain parts of the European markets. He says: “Despite the widespread view that industrial companies don’t have enough pricing power to offset cost inflation, there is still a very material valuation premium, particularly at the higher quality end.”
He sees a similar phenomenon in Telcos. “Can you push a 10-15% increase on lower income consumers that make up the majority of their base? It seems very difficult. Similarly for utilities – they have regulated cost bases and revenue bases – it’s very tough to put price increases on consumers.”
For Stoltz, that leads him towards areas such as luxury goods, with LVMH and Hermes in the portfolio, plus aerospace and defence companies and software groups. These areas all have pricing power, he says, in a tough environment.
There are long-term structural growth themes in Europe, but investors need to move away from the mainstream large-cap companies to get concentrated exposure to these areas at a reasonable price. European markets have seen the dominance of growth stocks over the past decade as elsewhere, so investors need to be wary on how they move back into European equities.
