Europe: Make Hay While the Sun Shines

All things considered, European equities have remained surprisingly resilient for much of 2023, with the Stoxx 50 and the DAX indices hitting fresh highs and outperforming the S&P 500.

The recession that looked inevitable in late 2022 has not yet materialised – at least from a region-wide perspective, while business sentiment, overly pessimistic in late 2022, hasn’t collapsed, in part due to fewer supply chain issues and hope surrounding China. 

European Central Bank (ECB) Vice President Luis de Guindos stated he expects the region as a whole to avoid a recession [1], but that was before the downward revision to Germany’s Q1 2023 output which showed a 0.3% decline quarter-on-quarter, following a 0.5% drop between October and December 2022. So far, high inflation and the energy crisis aftershocks have not derailed regional growth. However, time will tell whether the recession has simply been delayed rather than denied. 

Unlike in the US, European markets haven’t been able to call upon trillion-dollar Tech giants to underpin performance. Instead, Europe’s leadership has come from a more tangible source - luxury goods. LVMH’s market value briefly surpassed $500 bn, becoming the first European company to reach that milestone, thanks to booming sales in China and a strengthening Euro. The auto sector has also been a standout performer, with fewer supply constraints and a demand recovery in China.

Yet, despite benchmark outperformance against global indices, rising business confidence in the macro environment, positive Earnings-per-share (EPS) revisions and valuations below 10-year averages (unlike the US), sentiment towards Europe remains surprisingly mixed.

Some of the caution is due to concerns about the impact of monetary policy on growth. In early June 2023, ECB President Christine Lagarde commented that Eurozone’s inflation is still “too high” and the central bank will keep hiking interest rates though at a more gradual pace [2].

Inflation did fall sharply to 6.1% in May 2023 on the back of cooling energy prices, but the figure remains well above the ECB’s medium-term target of 2%. Further work still needs to be done.

Nevertheless, the earnings picture has been supportive, with the most recent results season posting the fourth-biggest beat in over 15 years. A net 36% of companies beat consensus EPS expectations during the quarter, while weighted earnings came in 13.4% above expectations at the index level, and the median EPS came in 8.5% ahead of consensus numbers. Stronger pricing power was an important feature of corporate results as Consumer Discretionary, Financials and Technology fared best when looking at both the breadth and size of EPS beats. In general, a higher proportion of European companies are seeing earnings upgrades compared to the rest of the world. The breadth of sales beats also improved from the previous quarter and remained positive.

Another positive for the region is that valuation remains favourable. As of 2 June 2023, the Stoxx 600 Index traded on 12.6x forward Price-to-Earnings (P/E), a significant discount to the S&P 500’s 19.3x.

Though despite a favourable resolution to the US debt ceiling debate, we should not be surprised to see further market volatility over coming months, given concerns about a weakening credit cycle, the sustainability of earnings growth, and the potential for negative macro surprises. Nonetheless, we still see value within European equities for investors  looking to build positions over the longer term.

Read European Equity Perspectives June-July, 2023: Europe: “Banking” on Volatility

UK:  Slow and steady wins the race

Last year’s equity market leader is proving to be this year’s performance laggard.

UK equities face many of the same challenges driving global markets, including soaring inflation and fears around growth. However, the UK’s version of the conditions has been more testing. Its domestic picture has had the additional distraction of widespread and painful industrial action, while globally-oriented names have been hampered by sterling’s strength.

UK’s inflation is proving to be extremely stubborn, as it was the only G10 country with double-digit inflation prior to April 2023’s reading that saw a decline back to an 8.7% rate. However, even this lower figure was still above expectations. This provides a bind for the Bank of England. In that context, UK money markets have started to price in a peak base rate as high as 5.5% by November 2023.

Despite this, recent data suggests the economy is actually holding up. The latest Office for Budget Responsibility and Bank of England forecasts indicate that the UK may avoid a technical recession this year. The UK also had its credit rating outlook revised to stable from negative by Standard & Poor’s, which said near-term downside economic risks have reduced. Expectations for public finances have improved in recent months, and chancellor Jeremy Hunt’s spring budget has extended the energy price guarantee, while postponing an increase in fuel duty. The government’s decision to abandon most of the unfunded budgetary measures proposed in September 2022 has bolstered the fiscal outlook.

Separately, progress towards a path forward with the European Union on trade through Northern Ireland (known as the Windsor Framework) is encouraging, and could remove a layer of uncertainty from UK assets this year. GfK Consumer Confidence, while historically low, is also at its highest since February 2022 (it rose to -27 in May 2023 from -30 in April 2023). In addition, the CEO of Currys Plc, the UK’s biggest electrical retailer, said there were signs that some consumers have become more willing to spend on big-ticket items, despite the ongoing cost-of-living crisis putting pressure on electrical appliance sales [3]. All of this have allowed for domestically-biased names to see traction in recent months.

Because of limited exposure to the high-flying Tech sector, the UK has not participated in the fear-of-missing-out hysteria around AI, but a pick up in market volatility going forward could also remind us of the value of one of the UK’s key attributes – defensiveness. We also still see reason to expect elevated interest rates and relatively stable oil prices – both of which play to UK’s strengths, especially its sizeable Financial and Energy sectors.  As such, the UK remains attractive on the back of supportive valuation (10.4x forward P/E) and high dividend yield (4.1% for the FTSE 100).