European equities, like the rest of the world, have been hugely overshadowed by their US counterparts for a number of years now. In fact, they have been so unloved, for so long, that they are now trading at a substantial discount to those headquartered over the pond.
When discounts are as large as they are, some would argue that there are investment opportunities to be had, while others still stress the potentials risks. So what is the right choice? To us, it’s a bit of both. We explore why here.
Key Takeaways
- Beyond being relatively cheap, European equities are looking more attractive as political stability has improved and a resolution to the Ukraine war could further boost investor sentiment.
- The European Central Bank (ECB) is expected to lower interest rates soon, which could ease credit conditions, boost consumer confidence and support market growth, particularly benefiting smaller companies reliant on bank lending.
- Europe faces major uncertainties, however, such as potential U.S. tariffs under Donald Trump and continued European Union bureaucracy impeding economic growth.
The attraction of Europe
There’s more to Europe at the moment than just a relative cheapness. For starters, its political instability is now on a more even footing. In the last 12 months, for example, two of its major economies, France and Germany, have been to the polls and, spurred on by the economic backdrop, change seems to be happening. The German government is pursuing fiscal and constitutional change with plans to unleash government spending - this increased spend alone would significantly add to both German and Europe GDP numbers. An increase in GDP should also increase growth in European companies’ earnings over the coming years.
Furthermore, any resolution in the Ukraine war will further benefit investor sentiment. The long, complex conflict has driven up energy prices and risk premiums across European markets, so even a ceasefire could significantly reduce uncertainty and allow energy costs to finally fall. For specific names in the industrial sector, this could be particularly important. Many businesses in chemicals, fertilisers and steel manufacturing will all breathe a sigh of relief after a protracted period struggling with high input costs.
Further adding to Europe’s investment attractiveness is the widespread anticipation that the European Central Bank (ECB) will lower interest rates - in the near future too. With inflation nearing its 2% target, the central bank is more likely to follow looser monetary policy, which in turn would improve credit conditions, leading to increased capital expenditure and boosting consumer confidence - all of which is beneficial to markets. Smaller European names, in particular, may be supported by easing monetary conditions given that they generally rely more heavily on bank lending.
Finally, investing in Europe doesn’t automatically mean solely investing in a continental story. Many European companies generate significant portions of their revenue globally. For instance, household names such as LVMH and Nestle are, to a certain extent, protected from any regional economic headwinds due to so much of their income coming from outside Europe.
European downsides
Despite these tailwinds for Europe, there still remain a number of downsides to consider. One of the most notable drawbacks to Europe’s investment case is the considerable uncertainty that overshadows the region at the moment, thanks to Donald Trump. Putting his diplomacy style aside, it’s his approach to trade policy, in the form of tariffs, which presents a large unknown for Europe. Europe will no doubt be in the new President’s sights to target with higher tariffs, as he has done with Mexico and China. With the U.S. being Europe’s largest trading partner, any uplift in tariffs could hurt corporate earnings and potentially even reignite inflationary pressures.
The uncertainty from Trump’s new government is further exacerbated by Europe’s historical problem of having a complex regulatory environment, which slows decision-making processes, hindering economic flexibility and power in the region. The regulatory backdrop also results in higher compliance costs and operational constraints for European names, further stifling innovation and growth.
Against this backdrop, Europe has struggled with a prolonged manufacturing recession too - where business activity has been lacklustre at best and credit growth has been weak. Arguably, the worst may be over with some indicators showing green shoots, but it still remains to be seen if (and how quickly) the region will recover. In fact, domestically focussed sectors continue to struggle.
It’s also vital to recognise that not all European stocks are undervalued in a meaningful way. For example, while financials and utilities do appear to be deeply discounted, technology and healthcare names are only trading at modest discounts.
Square Mile’s approach to investing in Europe
Even though some European equities are certainly starting to look more compelling than they have in years, it’s vital that we, as investors, remain mindful of the risks the region presents. The large discounts available in certain sectors certainly demand a closer look, but only when cautiously framed against the backdrop of US tariff uncertainty and regulatory inefficiencies.
To us, looking at the pros and cons of investing in Europe emphasises why taking a diversified, long-term approach, as we do, is so important. We advocate taking a balanced view of portfolio management because it helps to navigate uncertainty in the market which manifests itself as volatility. Our balanced view also crucially means that we can always target high-quality investments where the fundamentals do the talking - be they in Europe, Emerging Markets, the UK or beyond. Given the potential volatility and opportunity in Europe, we believe the environment should favour a more dynamic and active manager approach.
Mark, Chris, Dan, Matt, Scott and Florrie
Square Mile Investment Management Team
