European equities: A rising phoenix or a continuous fall?

From November 2007 to October 2022 was a one-way highway for US equities as the digitalisation accelerated at an ever increasing speed with technology giants such as Microsoft, Apple, Amazon, Nvidia, Alphabet (parent company of Google), Meta (parent company of Facebook), Salesforce, and Adobe conquering the world of the digital age. US equities outperformed European equities by a staggering 7.5% annualised outpacing even the run-up to the Dot-Com Bubble. The technology race was effectively lost by Europe many years before this period, but the ultimate crystallisation for investors was during this period. Nobody wanted to touch Europe. It was the old sick man of the global economy according to investors. Silicon Valley was where the returns were to be made.

European equities have outperformed US equities by 16.7% since October 2022 with the outperformance this year being 3.9% in USD terms. This significant comeback for European equities have made our clients more interested in European equities and wanting to understand this market. If we are right about the renaissance of the physical world as outlined in our Q1 Outlook, then European equities could continue to outperform.

Understanding the European equities and the STOXX 600 Index

Europe’s supersectors

The STOXX 600 Index divides its constituents into 20 supersectors defined by the Industry Classification Benchmark (ICB) which can be seen in the table below. The STOXX 600 Index is a free-floating market weighted index and thus we have used the free-float market cap which sums to €9.7trn which is lower than the previously stated market cap. The reason is that free-float market cap only measures the shares that are part of the securities markets. Some shareholders have a more permanent status and are thus not available for sale in public markets. In terms of number of companies the biggest supersector is the Industrial Goods and Services consisting of 103 companies with the three largest being Siemens, Schneider Electric, and Airbus.

The most profitable supersector measured by the return on equity (ROE) is Media with a ROE of 43.9%. The three largest companies in the media supersector are RELX, Wolters Kluwer, and Publicis Groupe. In terms of earnings growth over the past year the winner has been energy with earnings per share up 225%. Europe’s three largest energy companies are by far Shell, BP, and TotalEnergies.

The most expensive supersector measured by the 12-month forward P/E ratio is Consumer Products and Services and the largest companies in this supersector are LVMH, L’Oreal, and Richemont. A significant contributor to Europe’s outperformance since October 2022 has been luxury stocks which are part of this supersector as investors have looked for good bets on the Chinese reopening post its zero-Covid policy. Interested readers can read our equity note from 17 February on the global luxury industry which is dominated by European companies.

The most cheapest supersector measured by the 12-month forward P/E ratio is Automobiles and Parts and the largest companies in this supersector are Mercedes-Benz, Stellantis, and BMW.

A more diversified and cheaper equity market

Another interesting observation on European equities is the huge difference in GICS sector weights between the STOXX 600 and S&P 500. The biggest difference is in Information Technology with a 19%-points difference. US equities also have a higher exposure to Communication Services which includes media related companies such as Meta. European equities have a higher exposure to Financials, Industrials, Consumer Staples, and Materials (mining and chemical) which are all tangible-driven sectors. If we are right about reshoring, the geopolitical trajectory of the world splitting into two value systems, the green transformation and the tight supplies of key metals such as copper, the need for massive infrastructure spending then European equities should in theory outperform US equities. What we also observe is that European equity markets are more diversified and using the Herfindahl-Hirschman approach of comparing sum of squared weights we can conclude that US equities are 19% more concentrated on sector level than European equities. Being overweight US equities is essentially a significant active bet on technology companies to continue outperforming.

Another positive factor for European equities in 2023 is that forward valuations are much more intriguing with STOXX 600 trading at 13.2x on 12-month forward EPS compared to 17.8x for the S&P 500. In other words, US equities are valued at a 35% premium to European equities. Which is still in the highest percentiles of the US valuation premium range since 2008 and a convergence of equity valuations back to the historical average should provide tailwind for European equities. A key driver to close the valuation premium gap is to close the operating margin gap between US and European companies which has been significant since 2009, but over the past year with the comeback to tangible-driven industries Europe has closed a big part of that gap.