Gabriela:

Hello, welcome to On The Minds of Investors. My name is Gabriela Santos and I'm a global market strategist. Today's topic is, does investing in European equities still make sense? At the start of the year, the outlook for Europe looked bright as a result of an expected economic acceleration due to a surge in services spending once the Omicron wave faded, as well as due to the rebuilding of inventories as supply chain stresses slowly improved, especially in autos.

This easing of supply chain issues, combined with a better base of comparison for energy prices, was expected to reduce elevated inflation levels after the first quarter. European corporate earnings and markets were expected to outperform U.S. ones, given that cyclical sectors represent over half of that market's capitalization.

 In addition, longer term, the greater fiscal integration of countries within the block born out of pandemic necessity, but actually persisting beyond it with the 800 billion Euro next generation EU program was expected to lead to better growth and lower political risk.

Unfortunately, since the turn of the year, the long term outlook remains unchanged, but the short term one has darkened considerably. The tragic war in Ukraine has hit Europe particularly hard given its dependency on Russian natural gas, causing European prices to surge to historically high levels. And also its auto industry is very reliant on key inputs from Ukraine for its supply chain.

Currently, the question is not whether the region is eking out positive growth. The June Flash Eurozone Composite of PMI of 51.9 is consistent with about 1.5% GDP growth. But whether consumer and business confidence is deteriorating enough to land the region in a recession in the second half of the year. Confidence indicators have tumbled since Russia's invasion with June consumer confidence nearly eclipsing its historical low level hit in April of 2020.

In addition, the Composite PMI Future Output Index has seen a steep fall to the lowest level since October of 2020 with a particular weakness in manufacturing. Current activity has been supported by solid corporate and household balance sheets, record low unemployment rate, and fiscal transfers, but the short term risks continue to build. Most recently, due to concerns not only about the price, but also the supply availability of natural gas.

This tragic war in Ukraine has led to an indiscriminate selloff in European equities. Headlines will continue to weigh on sentiment for a bit longer, but the first quarter earning season has been strong. Compared to the U.S., Japan, EM, Europe actually had the highest beats on earnings, sales, and margins, and the highest earnings in sales growth in aggregate and for the median company.

Forward consensus earnings estimates have risen robustly in Europe as other regions have been flat to down. As markets eventually reconnect with fundamentals, this presents opportunity. Actually, historically low sentiment in Europe like today has coincided with strong future long term returns. On average, of 29% over the next 12 months following a sentiment trough.

There are three main reasons to not ignore the opportunity in European equities. Number one, recession fears in Europe are elevated, but investing in Europe is not a bet on the European economy necessarily. Over 50% of Europe's revenue comes from outside its borders.

For example, LVMH, it's a French listed, but a global luxury BA brand that sources revenue from all over the world, with 40% of it coming from emerging markets where there's growing demand from the rise of the middle class. Number two, most do consider Europe as a cyclical play, but it also represents structural growth opportunities. That's because European markets have experienced a significant change in sector composition since 2008.

For example, the Euro stocks 50, financials dominated that index at 35% back in 2008, but it's now less than 15%. Tech has risen from 6% to over 20% of the index. And this share is expected to grow further, with about 20% of the European recovery fund allocated to digitalize economies. And number three, investing in Europe offers exposure to opportunities not available in the US.

Europe is dominated in areas like luxury goods and also is at the forefront of the energy transition. 75% of offshore wind capacity is installed in Europe, and the EU is focused on phasing out its dependence on Russian oil and pushing forward with the Repower EU plan. This plan will cut EU dependency on Russian oil by two thirds by the end of 2022 and entirely by 2030.