In brief

• The attractiveness of the region’s equity market is rising, given a widening valuation gap to the U.S., which is extending at the sector level.
• Economic momentum is also building, and the potential earlier start to the rate cutting cycle by the European Central Bank (ECB) would support both the economic and corporate outlook.
• Investors should reassess underweights towards the region. However, muted earnings growth expectations compared to other major developed markets limit the strength of conviction. 

Despite lacklustre economic performance, the European equity market has had a strong run. Over the first quarter, the Euro Stoxx 50 index (the 50 largest companies in the eurozone) returned 12.9%, outperforming the S&P 500 over the same period. Meanwhile, the broader MSCI Europe Index is lagging the S&P 500 by less than two percentage points for the year.

The U.S. equity market rally is well supported from an economic and profitability standpoint. However, steadily rising U.S. valuations suggest that investors should be looking at broader global opportunities for returns. 

Europe looks good, relatively speaking

Like most developed equity markets, European equities have experienced a re-rating in valuations. However, unlike other markets, European equities could be considered fairly valued rather than expensive. At the end of March, the forward price-to-earnings (P/E) ratio of the MSCI Europe index was 13.9x compared to the 20-year average of 12.6x.

Where European equities appear more appealing is on a relative basis. European equity indices historically trade at a discount to U.S. indices given their differing sector composition. The U.S. S&P 500 has a larger weight to higher margin growth sectors, such as technology, which can command higher valuations. The European equity market is dominated by value sectors, such as energy and financials, leading to a lower relative valuation. Indeed, the rally in U.S. equites has created the widest index-level valuation gap to European equities in the last 20 years.

But that valuation discount applies across sectors, rather than solely being a function of sector composition. Every sector in the MSCI Europe index is trading well below their average long-run discount to the equivalent U.S. sector (Exhibit 1).

European companies think they are being undervalued by investors. Chief executive officers are buying back stock, and buyback activity is steadily increasing—a trend usually associated with U.S. markets. European equities have always been a source of income for investors given the higher dividend and payout ratios associated with a value-orientated market. However, the recent increase in buyback activity in Europe means the combined buyback and dividend yield on offer from the region is now over 4%.

Economic momentum building

European equities have managed to perform well despite recent weakness in the European economy. The economic weakness has been driven by an energy price shock and reduced export demand due to a Chinese slowdown, as well as weak labor productivity and rising interest rates.

Source: MSCI, Standard & Poor’s, J.P. Morgan Asset Management. (Left) LSEG Datastream. (Right) FactSet.
Data are based on availability as of March 31, 2024.

However, economic activity has likely bottomed, and momentum is expected to build in the coming quarters. The most supportive aspect for the economic outlook is the potential for consumption to rebound. Household spending should be supported by now positive real wage growth and a still elevated level of excess savings built up during the pandemic. Falling energy costs will also benefit household finances and support consumption.

Cheaper energy would also benefit the manufacturing sector. Survey indicators of manufacturing remain depressed, but have improved in prior months. Given manufacturing’s greater weight in the European economy, any increase in global goods demand may have larger positive economic impact relative to other developed economies. However, the full effect would only be felt if the boost in demand extends from technology-related goods to more industrial goods, or if a stronger rebound in Chinese activity materialised. 

ECB to make the first move

This weak growth backdrop, coupled with much lower inflation, sets up a strong case for the ECB to begin its rate cutting cycle in June and ahead of the U.S. Federal Reserve (Fed). Compared to the Fed, the ECB has set itself a high hurdle to not cut rates given economic activity is below potential, and there is little sign of strong consumer demand or elevated price pressures in goods. While services inflation is proving trickier to tame, the ECB expects wage pressures to fade as the tightness in the labor market eases, coupled with a forecasted rise in labor productivity.

Given this, the market is more confident in the eurozone rates outlook pricing an early start to the easing cycle compared to the U.S. Lower rates may lead to improving business investment, as well as corporate margins, given that investment in the European corporate sector relies more heavily on bank financing than market-based financing (e.g. bond issuance) compared to the U.S. Approximately 70% of corporate financing is bank-based in Europe, compared to around 30% in the U.S.

The need for speed (in earnings)

The headwind to a strong investment case for European equities is the current earnings outlook. For the 2024 calendar year, consensus earnings growth for the MSCI Europe index is 4%, rising to 11% in 2025 (Exhibit 2). This is an improvement on prior years, including 2023’s flat outcome, but the pace of expected earnings growth is not as fast as other regions such as the U.S., or parts of emerging Asia outside of China. 

Investment implications

The improving economic backdrop in Europe, coupled with attractive relative valuations, suggests a more constructive outlook for the continent’s equity market.

Europe is a region that has been unloved by investors. However, any underweights towards Europe’s equity market within global equity allocations are worth reassessing.

A strong conviction and portfolio allocation towards the region would require an increase in earnings expectations as well as upward revisions to economic growth estimates, based on stronger consumer behaviour and a broadening out in manufacturing recovery. 

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