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Written by: Richard McGrath | AGF
By its own standards, the European equity market enjoyed a strong first quarter, with the MSCI Europe Index returning about 7%. For a market that has limped along at a roughly 4% annualized return over the past 10 years, that was a pretty heartening performance. Yet any enthusiasm European stocks inspired in investors in Q1 may be tinged with a hint of jealousy: other major equity markets – notably, the U.S., where the S&P 500 Index gained more than 10% – performed even better than Europe did. Of course, underperformance relative to the U.S. is nothing new for Europe. The world’s largest economy has long been the object of global investors’ affection, and to the extent that they pay attention to Europe, it has been largely relegated to the “friend zone” and is often overlooked.
Like love, however, equity markets can be fickle. And there is a case to be made that Europe is deserving of more than passing interest right now. Valuations are at or near historic lows, and the macroeconomic backdrop may be improving. The question going forward, then, is twofold: Are European equities poised to continue their (relatively) robust performance? And could they perhaps become more than a wallflower in the competition for investor enthusiasm?
To answer that, let’s take a closer look at the profile of Europe’s start to 2024. We can break Q1 down into two periods. During January and February, European markets rode high on enthusiasm for artificial intelligence (AI) and expectations of falling interest rates, much as U.S. markets did. European equity market returns were highly concentrated in the so-called GRANOLAS group of 11 stocks (GSK PLC, Roche Holding AG, ASML Holding NV, Nestle SA, Novartis AG, Novo Nordisk A/S, L’Oreal SA, LVMH Moet Hennessy Louis Vuitton SE, AstraZeneca PLC, SAP SE, and Sanofi SA), which comprise Europe’s sort-of version of the U.S. “Magnificent Seven,” but in fact market concentration was even more intense than the acronym implies. At one point, a mere five stocks accounted for 110% of overall market return (meaning, effectively, that the rest of the market was negative). The tide turned in March, however, when market returns became much more broad-based. The broadening was led by the banking sector. Quarterly results for the large-cap Euro banks initially disappointed investors, but they all rallied strongly to close the quarter.
One driving force for that broader rally late in the quarter was simply that valuations looked so cheap. It’s true that European stocks traditionally trade at a discount to their U.S. counterparts, and there’s good reason for that. Economic fundamentals in the U.S. have long been much stronger than in Europe, and this year U.S. real gross domestic product ( GDP) growth is estimated to come in five times higher than Europe’s. Also, U.S. equities tend to be more profitable than their European peers. Yet as much as fundamentals dictate that there should be a valuation discount on European equities, it has begun to look excessive. On a forward price-to-earnings basis, Europe has been trading at a record discount to the U.S., even after adjusting for sector weighting. That’s despite clear signs that the profitability gap with U.S. stocks is narrowing. Leading indicators such as the purchasing managers’ index (PMI) and better-than-expected corporate earnings results have been picking up. Meanwhile, return on equity (ROE) for the MSCI Europe Index has rebounded from pandemic-era lows more quickly than for the U.S. equity market – a disparity that investors seem to have largely overlooked.
We anticipate interest rate policy could also create tailwinds for European stocks this year. Both the European Central Bank (ECB) and the U.S. Federal Reserve (Fed) are in a quandary, but for different reasons. In the U.S., economic growth is strong, which is making the Fed reluctant to throw fuel on the fire by cutting interest rates. In contrast, the ECB faces no such growth “problem,” but inflation, particularly wage inflation, remains a key concern. So, it remains hawkish, but it may have more runway than the Fed does to cut rates when (or if) inflation approaches target. Current analyst expectations are for a 25 basis point cut from the ECB in June, with two more cuts in the second half of 2024. By comparison, some economists now expect the Fed to hold off on cutting rates until September, according to a recent Reuters poll. If interest rates come down faster in Europe than in the U.S., we believe the outlook for GDP growth and equity valuations could look much brighter.
Certainly, there are risks to this scenario. Inflation is one: it might prove stickier than expected, delaying ECB easing. Another is politics. The United Kingdom’s economically questionable Brexit experiment is no doubt fresh in some investors’ minds, but the upside is that few if any politicians in other countries are looking to campaign for similar exits from the European Union. A more pressing topic in Europe is immigration, which is helping far-right parties gain traction in the run-up to the European Parliament election in June. Yet polling suggests the far right is attracting only about 15% to 20% of voter support – enough to gain ground in the election, but not nearly enough to challenge incumbent parties for power.
None of this is to argue that Europe can or should be expected to usurp America’s long-held position as the destination of choice for many investors. The case for European equities as an opportunity for portfolio diversification, however, we believe appears to be increasingly valid. At the very least, the improving economic outlook and strengthening corporate profitability suggest that European stocks have not been getting as much love from investors as they should.
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