It’s no secret that US equities have been the darlings of investors over recent years. Driven in part by a handful mega cap tech stocks, the US market has delivered impressive returns, at least until recently.
By contrast, European equities have been largely shunned by investors, something that the latest figures from the Investment Association clearly demonstrate. While the IA North America sector saw net retail inflows of £415m in February, the IA Europe ex-UK sector suffered outflows of some £364m.
The contrast could hardly be starker, and this persistent divergence in investor sentiment means that European equities are now trading at a significant discount to their US counterparts.
Without dwelling on the broader market dynamics at play since Trump entered the White House, some would say European equities are now worth serious consideration from a pure valuations perspective, given the scale of their discounts.
However, risks still persist – and, as always, asset allocation is a nuanced exercise, balancing potential upsides with downsides. Europe is no exception.
The increased appeal of European equities is not premised solely on their low valuations relative to the US. Politically speaking, Europe is looking much more stable of late, with two of its main economic protagonists – Germany and France – having held elections over the past year.
As always, asset allocation is a nuanced exercise, balancing potential upsides with downsides. Europe is no exception
These seem to have ushered in a period of change, spurred on by the broader economic backdrop. In Germany for example, the government has initiated both a fiscal and a constitutional shift with an agenda of unleashing spending.
This alone could add significantly to GDP numbers – not only in Germany but across the continent as a whole, boosting the earnings of European companies over the coming years.
In addition to increased political stability, any reduction in geopolitical risk in the region is likely to improve investor sentiment towards Europe. Although the US-brokered negotiations seeking a ceasefire in the war between Ukraine and Russia continue to drag on, an end to fighting would be advantageous for a number of sectors.
Aside from the tragic human cost of the long and complex conflict, it has caused a spike in energy prices and risk premia across European markets. A complete resolution to the war may seem a long way off, but even a ceasefire could significantly ease uncertainty and lead to a reduction in energy costs.
Further reductions in interest rates by the ECB also create a more attractive environment for investors in Europe
This would benefit energy intensive industries, with companies involved in the production of chemicals, fertilisers and steel manufacturing in particular experiencing some immediate relief.
Further reductions in interest rates by the European Central Bank (ECB) also create a more attractive environment for investors in Europe. Inflation is currently approaching the ECB’s two per cent target, a sign that looser monetary policy may be on the horizon.
This in turn would improve credit conditions, encourage capital expenditure and boost consumer confidence, all of which are supportive of markets. In particular, smaller businesses that tend to rely more heavily on bank lending will benefit from a more lenient fiscal backdrop.
It is also important to remember that investing in many European companies does not necessarily equate to a punt on a continental story, given that they frequently play to a global market. At the larger end of the market capitalisation scale, household names such as Nestlé and LVMH generate much of their revenue outside Europe, protecting them to some extent from regional economic headwinds.
The initial uplift in tariffs is likely to hurt European corporate earnings, certainly in the short term
This is not to say that it is all plain sailing for Europe. Donald Trump’s long-anticipated Liberation Day has seen punitive 20% tariffs levied on all imports from the EU. The US is the EU’s largest trading partner and in the immediate aftermath of Trump’s announcement, European markets were hit, with those companies particularly reliant on exports experiencing a heavy sell-off.
While this announcement may be the opening salvo for further trade negotiations, this initial uplift in tariffs is likely to hurt European corporate earnings, certainly in the short term, and has the potential of reintroducing inflationary pressures.
Europe has also struggled with a prolonged manufacturing recession. Business activity has been lacklustre at best and credit growth has been weak. It could be that things have turned a corner and there are some signs of recovery. Nonetheless, domestically focused sectors continue to struggle, and there is no certainty over when or how soon the region will recover completely.
Some headwinds to European growth are homegrown. Europe is known for its a complex regulatory environment, which hinders decision-making processes, impeding economic flexibility and power in the region. The higher compliance costs and operational constraints associated with regulation has historically acted to stifle innovation and growth for European names.
Investors should exercise caution when considering European equities and not be blinded by the valuations story alone
It is also important to note that valuations in Europe are not universally low. While it is true to say that some sectors – financials and utilities, for example – appear steeply discounted, others, such as healthcare and technology, are only trading at modest discounts.
Investors should therefore exercise caution when considering European equities and not be blinded by the valuations story alone. This advocates an active approach to asset management in Europe and favours skilled fund managers who are able to navigate the market, identifying opportunities and avoiding pitfalls.
It is also essential to take a diversified, long-term approach to asset allocation. A balanced view of portfolio management helps mitigate market uncertainty expressed as volatility, while capturing the upside potential from high-quality investments where the fundamentals do the talking – be they in Europe, the UK, emerging markets or beyond.
Scott Spencer is investment director at Square Mile Investment Consulting and Research
