The case for European equity exposure

After a decent run since the start of the year, the US equity indices are now in technical downtrends again. Fundamentally as well, the case for more rate hikes is getting stronger, and US equities will likely remain under pressure from higher yields. In addition, margin compression is clearly a theme that is picking up in Q4 earnings outcomes, and will likely weigh further on US equities.

We have often voiced the importance of a balanced portfolio and the advantages of adding commodities to portfolios as an inflation hedge. In addition, this year also brings an opportunity to diversify portfolios by spreading out your investment across geographies. While the S&P500 is up ~4% year to date, MSCI Europe has recorded gains of ~9%. Most gains have come from a very strong performance in France’s CAC 40 index which is up ~13% YTD and Euro Stoxx 50 is up ~12%.

Improving macro fundamentals

After wading through the energy crisis last year without significant damage, the leading indicators for Europe have continued to gain strength since the start of this year. Flash S&P PMIs for February reported this week saw services PMIs for the region climb back into expansion and manufacturing improved as well. Sentiment indicators also continue to turn positive with natural gas prices down over 60% from the December peak and more than 80% from the August peak, easing cost pressures for businesses. In addition, Europe is better positioned to enjoy the tailwinds of a China reopening compared to the US due to the closer trade relations. In essence, the European economy appears relatively more resilient compared to 2022 when a recession was priced in.

Potential earnings upside

Lower cost pressures due to the slide in energy prices has helped European companies deliver better-than-expected earnings in Q4. Banks have also reported stellar results and luxury brands have come back in focus with the expected rebound in Chinese demand. Euro Stoxx 600 companies have delivered an earnings growth of 8.5% in Q4 compared to earnings decline of 1.4% for the S&P 500 companies, as on February 23.

Improved outlook for Chinese demand and restrained energy prices continues to boost earnings outlook. Meanwhile, the European Central Bank is expected to continue hiking for now, but peak rates are seen at 3.5% compared to 5-5.50% for the US. Still, the potential for an upward re-pricing of the Fed path is higher than that for the ECB, suggesting a relatively lower drag on the valuation of European stocks.

Value vs. growth

The outperformance of the European stocks vs. the US recently has also been driven by the brighter outlook for value stocks such as financials and commodities in the current high inflation environment compared to the tech-heavy US indices. This marks the beginning of the reversal of the post-GFC outperformance trend of the growth-heavy US indices.

The higher composition of tangible sectors in the European economy brings a structural advantage over the US peers, as higher interest rates necessitate more productive investments. The pandemic and the war have also exposed the supply-side vulnerabilities, sparking a capex cycle focused on developing the real economy. This means investments are going further into the tangible economy in order to ensure resilient supply chains, energy and food security and a strong infrastructure and defence cycle. These emerging trends will mean a re-rating of European stocks.

Attractive valuations

Despite the recent run higher in European indices, the valuation still appears to be attractive. Euro Stoxx 600 is currently trading at 13.5x forward P/E compared to its 10-year average of 14.4x. It is also trading at a discount to S&P 500 which currently has a forward P/E of 18.1x. The difference in valuation can in part be attributed to different sector compositions, with the US index comprising of more tech and fewer value stocks like materials, industrials and financials. But even with sector adjusted weights, European stocks are still cheaper that their European peers. Dividend yield for the European index, currently at 3.6%, is also better than that of the S&P at 1.7%. With large outflows from the European markets last year due to fears of energy shortages and a possible recession, many investors still remain underweight European equities and the room for catch-up is still seen.