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The Case for European Equities

Natalie Briggs

Natalie Briggs - Investment Director Equity Europe

The Case for European Equities

Summary

  • The economic outlook for Europe in 2024 remains uncertain. Although central banks are showing clear willingness to cut rates and the likelihood of the current soft-landing dynamics continuing for the entire of 2024 has risen, slowing credit growth and signs that consumer savings are exhausted mean we continue to think recession risks are elevated and will grow as we move through the year. That said, with relative valuations at historic lows despite improving corporate fundamentals and lower reliance on domestic economies, there is room for headway to be made by European equities over the year. 
  • European companies are more diversified from both a geographical and sector perspective, an important characteristic in a world with an anaemic global growth outlook.
  • We believe the increased weight of the Information Technology and Healthcare sectors in European indices remarkably improves the long-term growth outlook for the region, and the potential for companies to capitalise on Artificial Intelligence (AI) advances is under-appreciated.
  • ESG characteristics of European corporates remain favourable, and the theme continues to attract capital, whilst the green transition continues to disproportionately benefit Europe with its leading sustainable companies.

Risk warnings

  • The value of investments and the income from them can go down as well as up and investors/you may not get back the amount invested.
  • Past performance is not a reliable indicator of future results.
  • Foreign currency investments are subject to exchange rate fluctuations.
  • Funds promoting environmental and/or social characteristics, have a focus on securities of companies that take sustainability features into account. This may have a positive or negative impact on performance, even compared to investments that do not have such a focus. The sustainability characteristics of securities may change.
  • Investors should note that the views expressed may no longer be current and may have already been acted upon. Past performance is not a reliable indicator of future returns.
  • Reference to specific securities should not be construed as a recommendation to buy or sell these securities and is included for the purposes of illustration only.

Market backdrop

We entered 2023 with expectations of a looming recession and all major banks signalling their intent to continue with rate hikes. During the year, there were market events including the collapse SVB and the Signature Bank in the US, the failure of Credit Suisse in Europe, underwhelming Chinese post-COVID reopening as well as rising geopolitical tensions. Despite this unfavourable backdrop, equity markets had a strong year on the back of resilient corporate performance. 

Entering 2024, the economic backdrop is still challenging. The twin pressures of sluggish top line volumes and refinancing of upcoming debt maturities at higher rates are likely to pressurise profit forecasts and will leave some companies reliant on multiple expansion for meaningful share price appreciation over 2024. We expect companies with weak balance sheets to have to raise equity over the coming months if they do not see an acceleration in fundamentals. Such recapitalisations are typically very damaging to existing shareholders. 

However, as bottom-up stock pickers we believe that there are opportunities to identify individual stocks that are attractive, particularly in an environment where the weak economic backdrop has hit sentiment broadly and valuations look compelling.
 

Why should investors consider European equities now?

Gloomy outlook already baked into valuations 

Although European companies posted strong corporate results in 2023, the effect on valuation multiples was largely muted. Asset allocators remain underweight the region and consequently European equities saw outflows for much of 2023, driving the relative valuation versus the US market to still lower levels as illustrated in Figure 1. Just a small change in sentiment in favour of the region could start to reverse the trend, and the valuation gap will potentially start to close. The rest of this article will touch on some of the tailwinds which suggest it may be an opportune time to invest actively in European equities.

Figure 1: Europe vs. US 12M Forward Price to Earnings 
 

Superior depth and breadth  

From a revenue generation perspective, the European equity market is very well-diversified and not overly exposed to the region. Less than one third of the revenue generated by European-listed stocks comes from within the Eurozone (Figure 2). Emerging markets and the US account for an almost equal proportion of sales - it is fair to label MSCI Europe a truly global index. This compares to the S&P500 index where we see a much more pronounced reliance on the domestic US market. Clearly in absolute terms the US economy is larger - but from a revenue risk perspective, diversity of earnings is an attractive and often under-appreciated benefit of investing in Europe. 

The MSCI Europe index is also far less concentrated towards the largest holdings compared to the S&P as illustrated in Figure 3. A massive c.25% of the S&P500 is concentrated in just 5 names in contrast to only 13% for MSCI Europe. Furthermore, sector exposure is more diversified compared to countries such as the US and Japan where concentration in specific sectors is more acute. The US is heavily weighted towards IT stocks whilst Japan is skewed towards Industrials and Consumer Discretionary. In Europe, exposure is far less concentrated with no sector comprising more than 20% of the index.  

As such, with superior diversification and some insulation from domestic European economics, European stocks may benefit from an improved risk-reward ratio whilst also having a cushion against global headwinds. Further, the underappreciated distinction between the European economy and company performance may have led to negative economic sentiment being disproportionately detrimental to valuations. 

Figure 2: Index regional exposure 

Figure 3: Index concentration 

Changing sector exposure  

Over the last decade or so the Financials and Energy sectors have gone from almost a combined 35% of the MSCI Europe Index to less than 25%. In the same period sectors with strong structural growth drivers, Industrials, Health Care, IT and Consumer Discretionary have increased from 30% to 50%. This changing composition of the European equity market towards sectors that are positively impacted by structural trends including digitalisation, e-commerce and aging populations is a strong bottom-up driver for higher and more stable EPS growth. 

Whilst the European equity market lacks the high-octane growth companies that have driven the US market over recent years, many of Europe’s largest companies boast very attractive attributes of low volatility growth, stable balance sheets and good dividend yields.

Figure 4: MSCI Europe sector exposure over time

Under-appreciated AI beneficiaries

Artificial Intelligence (AI) was definitely the most hyped area of the market during 2023. However, a lot of the hype was around US companies developing the large language models (LLMs), like OpenAI with ChatGPT, or providing the chips needed to run them. Meanwhile, Europe also has a group of companies that have been quietly using these emerging technologies to develop new products that are already benefitting their customers. In our view, they haven’t been getting the investor attention they deserve, as the focus is on US-listed companies at the forefront of developing the technologies. This has resulted in the European-listed beneficiaries trading at more attractive valuations. 

LLMs’ effectiveness increases with the amount of data you feed in to generate insights and, in Europe, we are fortunate to have several companies that have evolved from offline data vendors to online data and analytics providers and possess vast amounts of data. Most importantly they are only in the early stages of benefitting from the additional capabilities AI brings to the analysis and insight part of their product offering. We expect companies like Experian, Sage, SAP and RELX to be strong long-term winners in this space.

Green transition creates opportunities 

European equities may benefit from the green transition, a long-term structural driver. Europe plans to be the first climate-neutral region by 2050 whilst leading the world in wind power generation, solar technology, developing environmental projects, automation, testing and electrification. To achieve Net Zero the EU has introduced initiatives such as NextGeneration EU and the Green Deal Industrial which will drive investment, boosting prospects for leading energy companies in Europe. According to McKinsey, cumulative incremental investments to achieve net zero could reach $1.7trn by 2030 and could lead to 5 million net job creation1

Europe is home to many “best-in-class” companies that we believe are well positioned to help global governments meet their net-zero emissions targets. For example, Infineon is a leading supplier of power semiconductors with >40% exposure to automotive and geared to electric vehicle (EV) production, which gives a long runway for growth as EV penetration rises to 2030 and beyond. European companies such as Sika, which sells innovative niche products to the construction and industrial sectors, are also well-placed to drive energy efficiency. Given that buildings account for 40% of Europe’s energy consumption, much of the Green Deal budget is likely to be directed towards reducing energy bills. Testing, inspection and certification company Intertek estimates that 40% of its revenues come from ESG related services and is the leader on quality assurance in solar panels.

Favourable ESG credentials 

Additionally, European companies screen the best globally from an ESG perspective, with >94% of the MSCI Europe Index assessed as A-rated or above by MSCI ESG. This compares to less than two thirds for other major world indices. As such, European equities may well benefit from lower risk including reputational and legal, providing them with a lower cost of capital. Indeed, as the investor base shifts to the millennial generation by 2030, increasing focus on ESG elevates potential reputational risks. 

Besides from a financial perspective, higher ESG scores in a world that increasingly appreciates the value of well-run, sustainable business models, the superior ESG profile of Europe may well drive future asset allocation to the region.

Figure 5: ESG rating comparison 

The key features of our European equity capability 

  • Fidelity International is the largest manager of active pan-European equity funds2. This provides a scale and breadth of resource that enables superior corporate access and client service. 
  • Our portfolio managers draw on the expertise of Fidelity’s in-house European equity analysts: a team of 373 sector specialists who are responsible for deep dive due diligence and work with their global counterparts to provide truly comprehensive stock coverage. 
  • Our focus on bottom-up stock selection is underpinned by our focus on risk management. The search for quality is core to our investment philosophy, seeking to reduce the risks of permanent loss of capital.
  • Integrated financial and ESG analysis captures the full range of fundamental factors impacting financial performance and long-term shareholder value.

2 By assets under management. Refers to funds sold cross-border. Source: Fidelity International, 2023.

3 Source: Fidelity International, 31 December 2023.
 

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