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#Investments — 28.07.2017

With An Appreciating Euro, Which Sectors Should Be Favoured On The Equity Markets?

Guillaume Duchesne

European domestic stocks and diversification: two investment themes to watch.

European equity markets are shifting their focus from one theme to another. Previously, investors were following the upward trend in interest rates. Now all eyes are on the euro’s appreciation. We look at how the euro’s movement is influencing sector preferences.

Since the end of June, European markets have been particularly sensitive to European interest rates. Economic growth and the anticipation of a change in rhetoric from the European Central Bank (ECB) were enough to trigger a surge in German bond yields of around 30bps. Bank stocks were the main winners of this movement (see our previous publication, Equities: Long Bond Yields Have Risen In Recent Months. What Are The Consequences?). More recently, investors have turned their attention to another important factor: exchange rates. When the euro/dollar topped 1.16 following the ECB’s meeting on 20 July, it started to cause some investor jitters. Indeed, European companies are highly exposed to international markets (slightly less than half the companies in the Euro Stoxx 50 index are not domestic). Consequently, an appreciation in the euro will be bad news for numerous companies publishing their results, either because they may become less competitive and/or be penalised by a less favourable exchange rate when they repatriate foreign revenues.

In this context, the automobile sector has been harshly penalised by the markets (FX effects, collusion allegations in Germany, disappointing earnings reports). Statistically, other sectors which are impacted by an appreciation in the euro are chemicals, health care, consumer staples and industrials. On the other hand, utilities, real estate and banks usually outperform in periods of euro strength. Stocks linked to commodities (mining and energy) are also favoured.

The European reflation theme has been driving local stock markets for several months. European equities are still relatively cheap, buoyed by a more favourable political context in recent months. The stock market outlook remains good in the eurozone. However, in view of the current environment, we have a preference for Europe. Although the strategy in favour of European domestic stocks remains extremely relevant, portfolio diversification along the same theme is also necessary. The European reflation theme may still be played via pro-cyclical stocks (financials, corporate services, etc.). Despite the more volatile-than-expected environment, banks should continue to outperform this year (+5% year-to-date) thanks to a gradual improvement in return on equity (RoE). However, more defensive domestic stocks (telecoms and utilities) offer an attractive means of diversification because they are cheap, and barely exposed to currency swings.

Portfolios must also be built along another, more structural, investment theme: secular growth. This theme covers sectors which benefit from long-term growth markets. Among them, technology and health care may be favoured, but valuations must be monitored.

In conclusion, the European reflation theme remains appropriate for equity markets, albeit with more diversification.  Financials, telecoms or even certain domestic industrials (infrastructure, corporate services, etc.) should perform nicely. On the other hand, internationally-exposed sectors (e.g. automobile, consumer staples) are more risky. Lastly, European equities have more upside potential than US stocks (higher valuations).