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Since the onset of the global financial crisis (GFC), European equities have been buffeted by headwinds that have led them to persistently underperform their US peers. Now, I think, we are about to see a structural shift. While sections of the market remain vulnerable to temporary underperformance, I believe that European equities are in the best structural position that they have been in for years.
Since 2007, European equities (STOXX 600 Index) have underperformed US equities (S&P 500 Index) by 61% in US-dollar terms (Figure 1).
Earnings growth is the main reason for this underperformance. Since 2007, the total earnings of S&P 500 constituents grew by approximately 120%, compared to only 36% for their European counterparts.
The key factors causing this systematic underperformance include:
In my opinion, Europe’s long-term outlook has improved meaningfully, and I believe this is due to five important factors:
More fiscal spending — After more than a decade of austerity, the European Union (EU) is using coordinated fiscal spending as a key tool to tackle critical issues such as the energy transition and digitalisation. Key initiatives include:
Positive rates — I see structurally higher interest rates as supportive for European equity markets given the overweight to value stocks, which are typically more resilient to higher rates, and “old sector” incumbent companies. Growth stocks, particularly disruptor companies, have longer cash-flow and profit cycles and are therefore more sensitive to higher rates. Europe has few disruptors but many disrupted companies that can cope better with this new environment. For instance, in the telecommunications sector, we have witnessed revenue growth in the mobile telecoms market for the first time in 15 years as higher debt costs have forced new entrants to increase prices, enabling incumbents to follow suit. At the same time, growth stocks look unusually expensive relative to value stocks globally (Figure 2).
Banks’ improving profitability — Negative rates compressed banks’ net interest margins, but this pain is now receding. Over time, I anticipate higher valuations for European banks as this still important market segment starts to reflect its improved profitability.
Exposure to the next “supercycle” — While Europe was largely left on the sidelines during the tech cycle, European companies are well positioned for the new energy-transition cycle. Credit Suisse has identified 42 companies in Europe, representing around 15% of Europe’s total market capitalization, which it considers leaders in energy transition or sustainability. Moreover, European companies involved in the energy transition stand to benefit from strong fiscal and regulatory support in Europe and the US.
Attractive valuations — While I don’t expect the valuation gap between the US and Europe to close, the four factors above suggest it could narrow significantly. Compared to the US, Europe looks unusually cheap relative to its 10-year norm. This holds true against a wide range of valuation measures, be it sector-adjusted and growth-adjusted price-to-earnings or shareholder yield.
In my view, European equities face three key risks over the longer term:
In the short term, it is harder to make a constructive call on European equities in a global context. Europe’s international exposure and high number of cyclical companies make it vulnerable to a potential slowdown in the US or a faltering Chinese recovery. The European Central Bank’s most recent bank lending survey already points to deteriorating lending conditions and slower economic momentum.
In the short to medium term, I think it is important to adopt a more defensive stance. I am particularly cautious on European consumer and industrial cyclicals, as they appear to be pricing for an economic recovery that seems too optimistic.
From a structural perspective, I observe a wide range of areas that may benefit from the five key trends discussed above, but three areas in particular stand out:
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