The pandemic and energy crisis have galvanised the region's leaders and put an end to a prolonged period of punishing austerity and negative interest rates.
European equities broadly outperformed US stocks for the 18 months from late 2021. Initially benefiting from a global rotation away from growth to value stocks, subsequent momentum was driven by earnings upgrades as Europe coped much better without Russian gas than had been feared. However, since mid-2023 the US has pulled ahead, and European stocks now trade at near-record discounts to their US counterparts. This has led some investors to question whether Europe’s turn in the limelight was a one-off. Our view is that on a medium-term horizon, the region’s outlook has structurally improved. We think investors might therefore want to reconsider this unloved part of the global stock market.
Emerging from the doldrums
Younger investors, or those with short memories, will not recall a time when European stocks were the engine of portfolio returns. Between the global financial crisis and the Covid-19 pandemic, the S&P 500 rose at an annual rate of 11%, versus just 2% for the MSCI Europe in US dollar terms.1 European stock prices languished because earnings languished. S&P earnings grew by 14% per year on average in this period, while European companies could not manage that growth rate over the entire decade.2
But European stocks were not always laggards. Equity investors with longer memories will recall that after the dotcom boom, Europe’s indices were the darlings of developed markets. From 2003 to 2007, the MSCI Europe recorded an annualised price return of nearly 20%, almost double that of the S&P 500 (Exhibit 1). Equally, trailing earnings grew at an astonishing rate of 26% per year on average, again close to twice the earnings growth achieved by the S&P 500. While we do not see Europe returning to that magnitude of earnings expansion, it is worth remembering that the region’s equity market has not always been an underperformer.
Austerity was a key part of Europe’s “lost decade”
Europe’s stagnation in the decade leading up to the Covid-19 pandemic was unsurprising given the challenging macro environment. The eurozone lurched from the global financial crisis to its unique sovereign debt crisis, which sparked an extended period of fiscal austerity. The scale of the fiscal restraint across government investment, employment and public sector pay was dramatic (Exhibit 2).
Deeply contractionary fiscal policy forced European monetary authorities to adopt ever looser monetary policy in a futile attempt to meet their inflation targets. Both the economic and policy landscapes diverged from the US, and the term “US exceptionalism” became more widely used to characterise the US’s economic and stock market outperformance, which in turn put upward pressure on the dollar.
Sector composition didn’t help
The sectors that dominated many of Europe’s benchmarks in this period were also those that felt the post-financial crisis drag of low growth and low interest rates most acutely. The sector composition of European equity indices leans towards financials, energy, industrials and mining (Exhibit 3). The introduction of zero or negative interest rates to counter deflation risks caused banks’ return on equity to plunge, and Europe’s benchmarks were sadly lacking in the tech stocks that global investors were willing to pay an increasingly heavy premium for in a world in which growth was scarce.
Times have changed
However, recent structural changes mean Europe’s stock market’s turn in the limelight could be more than just a one-off. The European Union’s institutional framework has been reformed to allow common debt issuance to finance certain projects, which has dramatically changed the role fiscal policy will play in the economy over the medium term. An example is the Recovery Fund (also called NextGenerationEU), a scheme that allocates money for investment projects to member states if they implement certain structural reforms. The sums involved are vast – the potential grants to Italy total 5% of its 2021 GDP.
The scheme’s conditionality and the nature of the debt (issued at the supranational level) could also boost long-run productivity. For example, to receive Recovery Fund grants, Italy has had to implement a number of reforms to its judicial system, which has often been blamed for poor capital allocation and sluggish growth and productivity. While disbursement of Recovery Fund cash has been delayed thanks to shortages of materials and labour, alongside elevated interest rates, fiscal support will now extend over a longer period.
Europe has also coped surprisingly well with the war in Ukraine. Soaring energy costs following Russia’s invasion of Ukraine in 2022 threatened to overwhelm the progress that Europe had made, with the region facing a prolonged period of high gas prices and the risk of rationing. However, having successfully replaced Russian pipeline gas with American liquefied natural gas, Europe has now survived two winters with its gas storage tanks little depleted. A combination of consumer and industrial prudence, and warm weather, led to relatively little drawdown versus normal seasonal patterns. As a result, wholesale gas prices have returned to levels seen prior to Russia’s invasion.
European governments have further announced additional spending plans under the REPowerEU programme, announced in spring 2022, and the Green Deal Industrial Plan, a response to the US Inflation Reduction Act which aims to incentivise domestic clean energy production, among other green objectives.
These joint spending programmes should not only raise medium-term nominal growth in the region but, in our view, also reduce the risk of a eurozone break-up, helping to justify a lower risk premium on eurozone assets. Put simply, populists in places such as Italy will find it harder to whip up anti-EU sentiment among the electorate while there are such obvious benefits to being part of the bloc.
Bond markets have noticed the change, stock markets are less convinced
The bond market appears to agree that the eurozone has been dislodged from its low growth, low inflation rut. Euro 5y5y inflation and interest rate swaps have risen, and now sit much closer to US levels (Exhibit 4). Medium-term pricing for the European Central Bank’s deposit rate has also settled at levels not seen since before the financial crisis.
However, despite the bond market’s recognition of the improved nominal growth picture, almost every sector of the MSCI Europe equity index trades at an above average discount versus the US market (Exhibit 5). If bond pricing is right and we are set to see higher average rates over the next decade compared to the last, equity returns could be supported across a much broader range of sectors than the growth-heavy leadership of recent years. Given Europe’s sector composition, a rotation towards value would aid the region’s equity market performance.
Beyond value stocks, the continent’s luxury goods companies and fiscally-supported climate tech and semiconductor firms may also offer opportunities for investors looking anew at European markets.
In our view, Europe’s medium-term outlook has structurally improved. The pandemic and energy crisis have galvanised the region’s leaders and put an end to a prolonged period of punishing austerity and negative interest rates. We expect this to support longer-term nominal earnings in Europe in a way that current valuations do not appreciate. For that reason, while we think investors may have been right to shun the continent’s stocks for much of the last decade, they should now reconsider the role of European equities in their portfolios.