Why European equities could be coming out of lockdown
Europe invokes strong feelings but, as investors, we have a duty to look at opportunities dispassionately. European equities lagged the rest of the world quite badly during the last economic cycle, returning 10.6% annualised in sterling, compared to 16% for the world index. The periods of greatest underperformance were 2011 (when the eurozone was thought to be in danger of breaking up) and 2016 (the Brexit referendum). Investors voted with their feet to avoid the perceived political risk of the European Union.
European equities are now cheap in comparison
Although Europe has great world-class companies, which often feature in the portfolios of the most euro-sceptic investors, global asset allocators are less keen on European equities as a whole. To start with, Europe as a market is relatively cheaper than the US, as it lacks the thriving technology sector that drives US markets. If you analyse European equities vs the US and the UK on a sector-by-sector basis, you also realise that the discount suffered by European shares widened during and after the two periods of underperformance (2011 and 2016), without ever narrowing back. There is therefore a pent-up ‘return to normal’ valuation for European stocks, provided regional politics stops creating headlines.
Is political risk in Europe finally subsiding?
Ongoing disagreements between northern and southern European countries, each with a different philosophy about government borrowing, can all be traced back to one word: ‘Schuld’ in German and Dutch, ‘Skylla’ in Swedish and ‘Skylden’ in Danish - a Germanic root word that means both ‘debt’ as well as ‘guilt’ or ‘blame’. No wonder northern Europeans have a different attitude to borrowing money compared to other parts of Europe. The English have inherited the word debt from the Latin and it doesn’t have any negative connotations. For ‘Schuld’-based countries though, the distinction is between the ‘frugal north’ and the ‘spendthrift south’, a fight that is at the core of most intra-European debates.
European solidarity took a beating during the COVID-19 outbreak in Italy, the first western victim of the virus. The Italian health system was overwhelmed, the country went into total lockdown way before others and the toll was horrendous (although it has since been overtaken by Spain and the UK). Italians felt they had been let down by the European Union, with a huge political impact.
Recent headlines, though, have been more constructive for the Euro area as a whole. Chancellor Merkel of Germany and President Macron of France have proposed a plan for the EU to issue joint bonds to help the countries that suffered most from the pandemic, with Italy and Spain at the top. As usual in Europe, disagreement and debate will go on, but there is a real possibility of a deal that could reduce the semi-permanent political risk premium for European equities. If this should be the case, the upside for European shares is large.
European shares could also receive a boost from being more ‘cyclical’
One additional factor to take into consideration is the different make-up of world stock markets. The US market is full of technology and healthcare; the UK has energy, materials and banks; but Europe has many cyclical businesses - those that tend to follow the ups and downs of economic cycles such as industrial exporters and capital goods manufacturers. This makes European equities highly volatile.
But let’s look at what is currently happening in the world. The recovery from lockdowns is looking very strong. Some of the numbers for manufacturing surveys are very close to pre-COVID-19 levels. Obviously, services will remain challenged while we have to keep social distances, but industry is recovering fast so this is a backdrop against which European equities could do well. Quality businesses exist everywhere, but sometimes the make-up of a market is as important as the stock-picking - and Europe may well be front and centre of a cyclical recovery.
In our last markets update, we talked about political issues coming back to the fore for investors and while trade war, Brexit and US election headlines may continue, we think Europe may finally offer a glimmer of hope. As Europe works to hold together and also boasts many cyclical businesses which could benefit from the current market recovery, we have decided to put our traditional reservations behind us. Alongside our thematic ESG (environmental, social and governance) ideas, we are also more positive about European equities for our clients’ discretionary portfolios.
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Investment involves risk and you may not get back what you invest. It’s not suitable for everyone.
Investment involves risk and is not suitable for everyone.