The strength of the economic rebound is particularly important for European equities since their indices have a greater bias towards cyclical sectors, such as industrials, financials, materials and energy, compared to the S&P500.
Chief Market Strategist, Asia Pacific
Asian investors have traditionally focused on China, the U.S. and Asian markets for their equity allocation. Although U.S. equities continue to deliver an impressive performance in 2021, European equities have delivered some pleasant surprises in the past year, as well as since the start of the year. MSCI Europe delivered 10.6% return year-to-date, slightly behind 11.5% from S&P500 but ahead of the 10% from MSCI Asia Pacific ex-Japan.
There are several positive factors at play that could continue to support European equities.
Regarding the pandemic, Europe started 2021 reeling from a surging wave of COVID-19 cases but strict lockdown measures are helping to push the new infection number down again, allowing governments to ease some mobility restrictions. On vaccinations, while Continental Europe had a slow start relative to the U.S. and UK, the pace of inoculating its population is accelerating, with 3 million doses administered every day and 25% of the European Union’s (EU’s) population receiving at least one dose of the vaccine. This would imply over half of EU’s population should be fully vaccinated by the end of the summer. Borrowing the experience of the U.S. and UK so far, this should allow a substantial amount of consumer services to restart.
Although the 1Q 2021 GDP data reflected the damage to services in the most recent wave of outbreak, the manufacturing sector is in very strong shape. Both March and April manufacturing headline Purchasing Managers’ Index were above 60. The 62.9 reading in April was the strongest since the data series began in 1997. This reflected strong orders and output. Manufacturer optimism was also at a nine-year high.
This economic recovery is important to support corporate earnings. 1Q corporate earnings are beating expectations by a large margin, with 72% of Stoxx600 companies reported thus far outperforming expectations. The strength of the economic rebound is particularly important for European equities since their indices have a greater bias towards cyclical sectors, such as industrials, financials, materials and energy, compared to the S&P500.
Another important consideration is the role of economic stimulus. The U.S. government has already implemented three rounds of fiscal stimulus since the pandemic began in March 2020. Another large infrastructure spending plan is under discussion. In the EU, the recovery fund is also taking longer to implement, which could contribute to the region’s long-term growth outlook, instead of being just a shot in the arm. Contributing to long-term structural developments arguably would be more beneficial, especially if the European economy is already starting to recover from the pandemic.
EXHIBIT 1: EARNINGS GROWTH
EARNINGS PER SHARE, YEAR-OVER-YEAR CHANGE, CONSENSUS ESTIMATES
On monetary policy, there seems to be considerable division within the European Central Bank on whether the bond buying program should be extended. While the prospects of recovery would argue for some roll-back in emergency bond purchases, the prospects for inflation to hit the central bank’s 2% target in a sustainable manner still seem remote. This would imply interest rates should remain in negative territory for the foreseeable future, but the longer end of government bond curve could have some room to pick up. A steeper yield curve would be a positive factor for European banks and financial companies.
While it is reasonable for Asian investors to have U.S., China and Asian equities as their core allocation in equities, we argued at the start of 2021 that European equities could provide some diversification benefits and return-generating potential given their sensitivity to economic recovery and relatively lagged performance in 2020. After all, European companies are expected to go through a strong earnings rebound in 2021 after a very challenging 2020.
Although we mentioned above that the sector weight in European equity indices could benefit from strong performance in cyclicals, we believe sector and company selection continues to play an important role. Some exporters are in a better position to capture the recovery in the U.S. and China, with the latter being one of the few positive contributors to European export recovery.
Another reason for active management when investing in European equities is the role of environmental, social and governance (ESG) investing in Europe. ESG investing is already much better established in Europe, and this implies companies that have weak ESG ratings could face a greater risk of being excluded in portfolios. This factor may not be properly represented in traditional equity benchmarks. On a more positive note, the same applies to some of Europe’s "green tech" leaders that could contribute positively to reduce greenhouse gas emission.