Europe’s ‘lost decade’ of economic prosperity has been a concern for investors for some time now. Geopolitical uncertainty, the spectre of the sovereign and financial crises, and an outlook of low growth have all played their part in dampening investors’ appetite for European equities. However, we believe the landscape has changed – Europe’s recovering growth, increased business confidence and accommodative monetary policy indicate positive dynamics for investment that are not yet priced into attractive European equity market valuations.

This developing investment opportunity is also in part attributable to changes in political dynamics. Investors’ concerns surrounding the rising tide of populism at elections in Austria, the Netherlands and France proved to be unfounded, along with fears surrounding Brexit, at least for Continental Europe. Meanwhile, the US fiscal stimulus anticipated under President Trump’s administration has yet to occur. We believe that US equities are unlikely to rise further and given the legislative difficulties President Trump faced in his first 100 days; we do not believe there will be meaningful stimulus before mid-2018, further strengthening the investment case for European equities.

Valuation gap

In our view, US equities are at present overvalued. While strong fundamentals and positive growth have not been priced into European equities to date, investors are still applying a historically wide equity risk premium to Europe, versus the US.¹ They are currently willing to pay a premium of 4% for owning US equities, which contrasts with the 7% being applied to European equities. This gap widened after Europe’s sovereign crisis, and has not closed yet, despite Europe’s economy recovering strongly, as we explain below.

Real GDP in the Eurozone has expanded for 16 consecutive quarters, growing by 1.9% year-on-year during the first quarter of 2017.² Italy has been growing at close to 1% annualised for two years now, while Portugal grew an impressive 4% annualised in the first quarter. Most Eurozone countries are now registering purchasing managers’ indices (PMIs) above 55, which would be consistent with annualised GDP growth of around 3%.³ This has been a high quality recovery, and we believe it is likely to be supported by continued dovishness from the European Central Bank (ECB).

The European recovery is also broad-based and we believe it offers diverse opportunities, unlike the US equity market, which is far more concentrated. In the US, to date in 2017, nearly 80% of market performance is narrowly concentrated on the top 10% of contributors. As an illustration, the famous FAANG - Facebook, Amazon, Apple, Netflix and Google representing approximately 11% of the S&P 500 index’s market capitalisation⁴ – have contributed to about a third of S&P 500 performance. In contrast, performance in Europe, and in emerging markets, is more widely distributed, with many sectors offering value. It is no wonder then, that we are seeing increased investor interest in the equity markets of both.⁵

Targeting Europe’s best

We strongly believe companies which have stable business models and are resilient to economic changes offer the best opportunities in Europe. Certain sectors which benefit from domestic demand will fare particularly well, in our opinion. These include the professional services sector and the consumer discretionary sector, which comprises a wide range of firms from automobiles to textiles to luxury products.

We believe that companies generating an economic return that structurally exceeds their cost of capital will outperform as the equity risk premium decreases across Continental Europe. One example is healthcare firms - particularly those offering healthcare services and providing equipment – which we believe are a value opportunity, while industrials with good franchises and good market share could benefit from the upswing in the marketplace. Financial institutions, meanwhile, accounting for approximately 25% of the market, represent a sector in which investors should pay close attention to what they buy, in our view. Certain banks offer attractive opportunities with strong footholds in very narrow markets, while others are shrinking their activities and focused on restructuring, so the sector is far from homogenous.

Europe is also home to more companies that are exposed to emerging markets than is the US, and this offers an indirect benefit. Like Europe, some key emerging market economies are picking up strongly, particularly in domestic-focused sectors which are benefiting from the cyclical recovery.

Despite its robust GDP growth, falling unemployment and optimistic business climate, investors have not yet priced in the ongoing cyclical expansion in Europe. We believe that this expansion will drive the upturn in European companies’ return on equity and, in turn, their valuation. Europe is no longer in its ‘lost decade’. It has most definitely been found, and we believe investors should be seizing this opportunity.

¹ Lombard Odier Investment Managers “A Conviction for Quality: Equity investing in a Post-Truth World” June 2017
² ECB, “Europe’s Economic Recovery And Implications for Monetary Policy: Speech by Peter Praet” Last Updated 6 July https://www.ecb.europa.eu/press/key/date/2017/html/ecb.sp170706.en.html
³ Lombard Odier Investment Managers Global Perspective “Europe Enters a Sweet Spot for a Change” May 2017
⁴ Lombard Odier Investment Managers “A Conviction for Quality: Equity investing in a Post-Truth World” June 2017 (as of 26 May 2017)
⁵ Lombard Odier Investment Managers “A Conviction for Quality: Equity investing in a Post-Truth World” June 2017