Looking ahead, European equities should stay supported given a substantial improvement in vaccinations, upcoming fiscal support, and a sizable valuation discount relative to the U.S. for a market that offers access to both the cyclical recovery and an inflation hedge.
Global Market Strategist
Listen to On the Minds of Investors
Going into 2021, enthusiasm was high about a global pandemic recovery. However, as the first quarter unfolded, the enthusiasm continued building for the U.S., while it waivered for other regions given slow vaccination campaigns and renewed lockdowns. As a result, U.S. equities took the lead once again. Quietly, the second quarter is unfolding very differently, with U.S. stocks more range-bound as “peak growth” conversations dominate, while some international markets like Europe outperform as the wave of enthusiasm rolls over to the continent. Looking ahead, European equities should stay supported given a substantial improvement in vaccinations, upcoming fiscal support, and a sizable valuation discount relative to the U.S. for a market that offers access to both the cyclical recovery and an inflation hedge.
In 2021, regional equity performance has been a tale of two quarters. In 1Q, the S&P 500 outperformed MSCI Europe ex UK by 250bps, while it has underperformed by 290bps in 2Q. The currency is part of the story, as in 1Q the U.S. dollar strengthened 3.7% against the Euro, while it has weakened by 4.2% this quarter. U.S. data has been fantastic during this time, with a 1Q earnings season that saw a near record percentage of companies beating expectations by near record amounts. However, U.S. multiples had already moved in advance of the fundamentals themselves, which are now playing catch up.
On the other hand, expectations are only beginning to move higher now in Europe, with four main reasons suggesting continued strong Europe performance:
- From vaccine laggard to leader: In the first quarter, much of the disappointment around Europe centered on its slow start to the vaccination process. In April, this rapidly changed, with the pace of daily vaccinations doubling as bureaucratic issues around procurement and distribution were ironed out. In fact, European countries are now vaccinating a higher share of their population per day than the U.S., with an average of 0.8% versus 0.6%.
- Taking the Fiscal Spotlight: In the first quarter, much of the enthusiasm about the U.S. centered on the unexpectedly large fiscal package approved in March. The attention is now turning to Europe, as countries are set to receive the first disbursements from the game-changing EU Fiscal Recovery Fund around mid-year, which will help countries around the region to recover on much more even footing this time around.
- A hedge for inflation: This quarter, investors’ focus has turned to the inflation debate. As we recently wrote about, cyclical sectors can provide a hedge against rising inflation – and Europe is a region that provides the biggest cyclical bang for the buck, with 55% of its market made up of cyclical sectors (versus 33% in the U.S.).
- Better starting point this cycle: Despite its recent outperformance, European equity valuations are still at a steep discount to the U.S. after a decade plus of underperformance: -18% current vs. -10% average discount based on the forward price-to-earnings ratio.