European stocks: Regime change and the valuation gap

Dirk Enderlein, CFA, Equity Portfolio Manager
2024-04-30
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We’re in a period of significant regime change, and as a result, leadership in the European equity market could look very different over the next three to five years than it has since the global financial crisis and the opportunity for stock pickers to differentiate between winners and losers could be especially attractive.

To understand the current market environment, we first have to go back to 2021, when we began to see a fairly dramatic bifurcation in the valuations of European stocks — meaning extreme valuations on the high end but also on the low end. This is only half the story though. Valuations could, after all, carry on in that state for an extended period. The market was really waiting for the opportunity to unleash change, and now I believe that time has come — with the return of inflation and the rise in interest rates.

Expecting more dispersion across the Continent

This new regime has created the potential for greater dispersion in performance throughout the European equity market and for more clarity about which stocks will be the new market leaders going forward. We have, of course, been through a decade in which technology companies, “disruptors” and the beneficiaries of cheap funding led the way. But we’re seeing clear signs of change — driven in part by the shift in the interest-rate environment, but also by accelerating growth in other areas, such as defence.

We’ve also seen a lot of investment in certain areas of technology, especially in software, where I think negative free-cash-flow generation will lead to underperformance among some stocks in the sector as investors focus more on profitability.

Importantly though, valuations haven’t caught up yet with these trends. We still see the same bifurcation in valuations that has been in place since the COVID era. What’s more, the process of valuation normalization could be a prolonged one. While it plays out, the combination of valuation extremes and an understanding of the ways in which company fundamentals are changing could be extremely powerful for stock prices, both positive and negative. I think this opportunity in equity markets will only be amplified by structurally higher rates in the bond market.

Where are the opportunities and risks?

Against this backdrop, there are a number of areas I think are attractive. Let me highlight two:

  • Defence equipment manufacturers — For years, defence manufacturers in Europe struggled as countries across the region underspent on defence. But over the past few years, defence budgets have gradually risen. This began with a push from the US under President Trump to increase defence budgets in the region closer to 2% of GDP, but it truly accelerated in 2022 after the Russian invasion of Ukraine. And importantly for defence companies, most of the increased spending is focused on manufactured equipment, as opposed to more troops. I think this change should lead to stronger earnings and growth in what may be a multi-year process.
  • European banks — I think certain banks in Europe are attractive, and that hasn’t changed as a result of the recent turmoil in the US and European banking markets. In terms of what distinguishes the more attractive opportunities, they have low valuations as a starting point. Many of them went through difficult times during the global financial crisis and subsequent years. They have had to clean up their balance sheets and have faced a variety of new government restrictions in terms of lending practices, which I think helped them to avoid bad decisions and end up in a healthier place today. As a result, there are now the green shoots of improving growth and ROEs. Some banks are also overcapitalized, giving them the option to return money to shareholders.

Along with these potential opportunities, there are also areas where there will likely be an ample number of losers. Two examples, in my view, are the property and REITs markets in Germany and Sweden — two markets that would generally be considered fairly conservative, but where, for a variety of reasons, some companies have increased their debt pile in recent years and now find themselves in a precarious position.

There are, of course, broader risks in the region that we must consider. One is the possibility that we end up back in an environment similar to late 2020, including a return to very low interest rates. It’s also important to be alert to the potential for a big surprise in inflation, to the upside or the downside. Lastly, the recent energy crisis is worth considering, and in particular the potential fallout if we were to see a significant expansion of the war in Ukraine.

The bottom line is that Europe is a place where we have historically seen a great deal of bifurcation between winners and losers — across countries, sectors, and the region as a whole. In recent years, that changed as a smaller set of companies, particularly in technology, dominated, but I expect a return to a more diverse market with a very different level of dispersion going forward. Whenever the stocks that drive dispersion change, opportunities are abundant.

Expert

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