Five structural trends for Europe

In this video update Niall Gallagher, Investment Director, Europe Equities, discusses the key structural trends which he believes define a new investment era, reiterates why for him a style-agnostic approach to investing is essential and reveals how investors could play the artificial intelligence (AI) theme in Europe.

17 April 2024

What do current macroeconomics mean for European equities?

The most important is a greater sense of economic optimism. The long-standing, long-awaited decline in the US economy has not happened. And I think there is increasing evidence that things in Europe are getting better. Certainly on the consumer side, as we look into the remainder of this year, I think a combination of falling energy prices, falling utility prices, falling food prices and rising wages should be very good for consumption in Europe. We are also seeing evidence that industrial activity is beginning to bottom and potentially improve. In our asset class, there is a realisation that certain parts of it are still cheap in valuation terms. We have seen strong performance from European banks this year; I think the world has finally woken up to the fact that the banks on five and a half times earnings, with dividend and buyback yields of 15% in some cases, is just the wrong valuation. The banks have repaired their balance sheets. They are generating decent levels of return on equity, so they are profitable. That is beginning to attract interest too. So we have had a number of things which have catalysed a good start to the year. We think the fundamentals on European equities look good too; we have had a pretty good set of Q4 results and positive guidance from our companies. So I think it could be an attractive year for equity returns in Europe.

Can you discuss the key structural trends you are following?

We have spoken a lot about five key structural driving trends that really define what we think is a new investment era. After the global financial crisis up until the end of the pandemic, there was a very distinctive era for investment which was characterised by deflation, very low interest rates, negative in some cases, very low bond yields, low nominal growth, quantitative easing. That era was particularly good for certain types of stocks, namely high quality, low volatility, long duration; essentially quality growth. Some of the macro settings are now a bit different. We think inflation is likely to be more persistent and more volatile. Energy prices are likely to be structurally higher because of a lack of investment in hydrocarbons, and also because of the cost of the energy transition. And the energy transition itself comes with vast investment requirements, all of which creates a slightly different set of drivers behind markets.

The first of these key structural trends is the impact of a normalisation on interest rates and yields, which is obviously good for European banks because it raises their profitability. It is not so good for business models based on the assumption of zero rates forever, and we have seen a few casualties of that already. Second is the implications of higher energy prices, which are obviously good for oil and gas companies, but not so good for users of oil or gas; there are winners and losers there. Next is the huge opportunities that come from decarbonisation. For us, it is about trying to get behind those businesses that will benefit from higher capex, which will come from the multiple ways in which large sums of money will get spent to support the energy transition. Then there is the continuation of a long-standing trend of growth in the Asian middle class, which benefits premium consumer and luxury companies in Europe. And finally, many of our long-standing technological trends as well, which feed into certain types of business in Europe which support technology expansion. This includes areas like semiconductor capex equipment and so many industrial companies that also support those industries.

In terms of how we think about these themes from a sector positioning perspective, we have a bias towards banks in southern Europe where we think there is still plenty of value. We are overweight energy; oil and gas stocks are cheap and generating plenty of cash. They also have a significant role to play in the energy transition themselves as people who invest in low carbon technology and charging networks and potentially renewable generation. So beneficiaries should include energy transition companies and electrical equipment manufacturers, maybe making cables or some of the equipment going into transmission grids. Companies refurbishing buildings or providing capital equipment into industries which require investment to take carbon out of their production processes should also benefit.

We have also previously spoken about businesses involved in the transition to electric vehicles (EVs). Car companies will have to rebuild their plant, they will need new equipment, and that potentially benefits some of our holdings. In terms of companies that benefit from the rise of the Asian middle class, we have a lot of luxury and premium consumer holdings. And then in technology, semiconductor capex equipment, some of our industrial companies. But it is important to remember we are not top-down investors; therefore we have other companies that are doing their own thing, benefiting from their own outstanding business attributes.

What could be the catalysts for either opportunities or risks?

We are of the view that the consumer environment is picking up in Europe as the big energy shock begins to unwind and fades from the memory. We still think energy prices will be volatile, but we have to just bear in mind how high energy prices went in Europe and the damage they did. We think inflation will come down a little bit, but will remain higher than it was before and it will be more volatile, although not at the levels of the last two years. We think those will allow for a growth in real wages and some of the other expenses that consumers are exposed to, like utility bills, also come down. That benefits consumers too. So the catalysts are largely positive. There are some areas of the market that we think have become a bit overcooked; for example many of the growth type stocks became very expensive during the era of zero rates and zero yields. Some of these stocks have been pushed back up again in valuation terms as the market began to discount a fall in interest rates. If rates do not fall, or if it does not happen as quickly as people think, we think there are some growth equity stocks in Europe which are vulnerable to a valuation compression, and we would be careful about that risk as well.

Why is it important for you to adopt a style-agnostic approach to investing?

The five key drivers we have spoken about which we think shape the new investment era are more heterogeneous and more complex than the drivers of previous eras. Obviously if you are looking to invest in banks because you think rates will be higher than before and banks more profitable, or energy stocks because you think the oil and gas price is likely to be higher than it was before, and at the same time, want to invest in technology stocks or in luxury or the premium consumer you are combining stocks across multiple styles. To our way of thinking, it makes no sense to restrict yourself to one part of the style universe, because you will miss out on the other part. Our job is to pick the best stocks; we do not want to be constrained by style. This growth versus value thing is ridiculous, in my view. We want to invest in businesses that make decent returns, that have either got good growth or maybe have got a good return to the shareholder in terms of buybacks and dividends. Why would you not invest across the entire universe?

Are we seeing a structural move from the US to Europe?

I think managers have been calling for a move away from US equities for a long time. In support of that move, I would observe that US equities are highly valued. The Shiller PE, or the cyclically adjusted price earnings multiple, in the US is now trading at 34 times. If you turn that upside down, that is a 3% yield on US equities. The 10-year Tips, so real interest rates in the US are about 2%. So you are getting a 1% excess spread from investing in the US. That is a pretty rich multiple. History tells us that you should be a bit more cautious of that multiple. If I look at Europe the Shiller PE is 18.5, so nearly 5.5% in terms of a real yield. And even if I use US Tips as the real interest rate for the risk free asset that gives us a much bigger excess spread of 3.5%. So there is certainly a case in US versus Europe that Europe is cheaper. But I am just cognisant of the fact that people have been saying that for a long time. And even still, the US continues to innovate, produce great companies like Microsoft and Nvidia. Yes I would think it is a good time to be thinking about diversifying away from the US, not necessarily selling the US and buying other parts, but perhaps adding something a bit different to some of the outstanding US equities that clients might hold.

How best can you play the AI theme in Europe?

The businesses in Europe that have benefited most from the AI hype in the US have been the semiconductor capex equipment stocks, such as ASML, ASM, Be Semiconductor. Structurally, we like these companies, but I am a bit more cautious at current valuations. They have done really well and valuations are full. They may well grow at a high rate for the next five years or so, but the valuation is becoming a bit of a barrier to some of those stocks. So a bit of short-term caution; I like them but they are rich in terms of valuation.