Frédérique Carrier, head of investment strategy in the British Isles at RBC Wealth Management, discusses why European equities are transforming and why investors should take a fresh look at the asset class.

Frédérique Carrier at RBC Wealth Management thinks that European equities are emerging from their chrysalis with newfound potential. While it might be a stance that puts the firm at odds with some of its peers, the firm has set out in detail why the European position makes sense.

In her portfolios, Carrier has upgraded European equities to market weight from underweight in March. In her view, European equities present attractive opportunities, although misconceptions anchored in the past often prevent investors from seeking them out. She recently discussed the evolution of the European equity market since the global financial crisis, evaluating how to position portfolios advantageously.

Other wealth managers, however, prefer Japanese equities over European ones. Joost van Leenders, senior investment strategist at Netherlands-headquartered wealth manager Van Lanschot Kempen, smiles particularly on Japanese equities, over US and European ones.

In the case of Swiss private bank Union Bancaire Privée’s, equities are its core holdings - with preference for technology and Japan. “In 2024, Japan is offering premium, secular earnings' growth over European and emerging market equities,” Michaël Lok, group CIO and co-CEO asset management at UBP, said. See more commentary here and here.

A changing face
“European equity markets are often thought of as being dominated by “old economy” companies,” Carrier said in a note. This was the case 15 years ago when low-growth sectors, such as financials, telecommunication services (now called communication services), utilities, energy, and materials, made up a significant portion of the MSCI Europe ex UK Index, which comprises large and mid-cap companies across 14 European developed markets. “With lacklustre earnings' growth stemming from poor pricing power and a highly competitive environment, the stocks of many companies in these sectors have been languishing ever since,” she added.

“But the profile of the European equity market has seen a notable transformation,” she continued. “Those old economy sectors are now no more than a third of the index. Higher-growth oriented sectors, such as technology, healthcare, industrials, and consumer discretionary, now represent some 57 per cent of the index, a sharp increase from 37 per cent in 2011.” 

Changes are also afoot within industries. For instance, some of the formerly clunky and bloated conglomerates in heavy industries have slimmed down, spinning off underperforming operations to enhance capital efficiency, and are focusing on more modern, dynamic businesses and technologies, she added. The consumer discretionary sector has also been transformed. It enjoys greater exposure to high-margin luxury goods, having benefited from demand arising from the growing middle class in emerging markets.

The evolution of the index’s composition has had several notable consequences. For one, about 55 per cent of the revenue of index constituents is now generated outside Europe, lessening dependency on what has been an often lacklustre domestic macroeconomic backdrop, while providing exposure to economies with higher growth rates.

Moreover, European companies’ profitability, return on equity (ROE), earnings stability, and cash flow profiles have all improved. The ROE – a measure of profitability of index companies – reached 13 per cent at the end of 2023, up from 9.8 per cent in 2011, Carrier said.

Finding its footing
For the remaining 45 per cent of revenue generated within Europe, prospects have improved somewhat, in her view. The region narrowly sidestepped a recession in the second half of 2023 despite stomaching three shocks in a row: the pandemic, the sudden energy price surge following Russia’s invasion of Ukraine, and a harsh monetary tightening cycle. In fact, economic activity seems to have troughed, she continued.

Carrier highlighted how economic indicators such as the HCOB Eurozone Composite Purchasing Managers’ Index have been improving since last October. The European Central Bank’s (ECB) recent Bank Lending Survey points to lending conditions becoming much less restrictive. Real wage growth is improving amid falling inflation and, with markets widely expecting the ECB to cut rates in June, she expects the region’s economy will continue to stabilise in the coming months.

Carrier realises that the European economy does not have growth potential as high as that of the US – it is more highly regulated and has an ageing population. But consensus GDP growth forecasts are no longer being downgraded and are stable at 0.5 per cent and 1.4 per cent for 2024 and 2025, respectively.

However, if labour markets were to deteriorate, Carrier sees downside risk to these forecasts. Conversely, they could prove conservative if the Chinese economy were to improve, as Europe is a large exporter to that market, she added. Moreover, if bank lending picks up as business confidence improves, this could feed into stronger investment growth, another source of upside risk to consensus GDP growth forecasts.

A sheen of opportunity
Overall, as Europe’s economy is stabilising, so too are corporate earnings' forecasts. After declining for most of the past six months, consensus expectations now call for low-to-mid single-digit growth.

Valuations are not stretched, in her assessment. The MSCI Europe ex UK Index is currently trading on a 12-month forward price-to-earnings (P/E) ratio of 15x, in line with its 10-year average. Carrier notes, however, that over the past 12 to 18 months seven European quality growth leaders with global footprints including Novo Nordisk, the obesity and diabetes drug manufacturer, and ASML, the producer of extreme ultraviolet lithography systems for semiconductor manufacturing, have largely driven stock market performance and seen an expansion in valuations. Stripping out these companies leaves the rest of the stock market on a lower valuation, Carrier said.

Relatively, European equities are trading on a sharp discount to US shares, she added. Adjusting for sector weighting differences, the valuation discount is particularly stark. The Continent’s P/E ratio relative to that of the US, excluding the tech sector, is at its lowest level since the EU sovereign debt crisis in 2011.

A record number of European companies, particularly those with a strong balance sheet and a healthy level of cash, are also increasingly buying back their own stock to boost earnings per share growth and improve their valuations, she said. Carrier also notes that during recent earnings' announcements more and more management teams have been mentioning plans to return capital to shareholders.

Building balance
Given that the improving macroeconomic backdrop is set against a relatively low-growth environment, Carrier prefers a balanced approach to stock picking. She favours pairing high-quality secular growers, or global leaders listed in Europe, with selective exposure to more cyclically sensitive names, particularly in the industrials sector.

Long term, she prefers the technology sector (particularly mission critical software and semiconductor manufacturing equipment), healthcare, and industrial names with exposure to the capital expenditure supercycles related to the themes of decarbonisation, deglobalisation, such as reshoring, and higher defence spending. The luxury goods segment, within consumer discretionary, also benefits from powerful drivers, in her view. By contrast, Carrier has a more cautious view of the utilities and consumer staples sectors.