Time for Europe
Until recently, sentiment towards the continent’s equity markets had long been poor for various economic and political reasons and not been helped by Russia’s invasion of Ukraine. Yet, while not immune, markets can and do detach themselves from the surrounding noise given their focus on the corporate outlook – decades can testify to China’s robust economic growth having little effect on its stock market. Europe’s valuations are now at a record low compared to the US market. There is very little good news in the price. At a time when investors are beginning to question the valuations of the larger US technology companies, and seek better risk-adjusted returns elsewhere, this may change given the outlook for corporate Europe and markets are improving more than sentiment suggests.
The problem
Many of the continents’ woes were recognised well before Ukraine. The economy has been largely moribund for years. In 1990, the EU’s 12 member states represented over 26% of the global economy – today that figure for its 27 members has dropped to just 16%. Given the increase in member states and population, this is a poor outcome. The problem is so acute that Mario Draghi, the former chief of the European Central Bank, cited in his long-awaited ‘The future of European Competitiveness’ report last year that, given the EU’s ageing population, its economy will be no bigger in 2050 than it is today. He said if the current rate of economic decline cannot be halved, the EU faces an uncertain and poorer future – if not political irrelevance. He pulled no punches: “For the first time since the Cold War, we must genuinely fear for our self-preservation.”
Competitiveness is the root cause of the problem. Draghi went further: “We claim to favour innovation, but we continue to add regulatory burdens on to European companies which are especially costly for small and medium-sized companies”. This bias towards regulation has stymied growth and remains evident – contrast the EU’s approach to Artificial Intelligence (AI) with that of the US and UK. By way of illustration as to the extent of the problem, despite the UK’s mediocre economic record vis-a-vis the US, since Brexit our growth rates have been among the best in Europe, with unemployment remaining well below the EU average, and some years when inward investment has been twice that of France and Germany combined.
Europe’s other problems are well-rehearsed. The war in Ukraine staggers on at great cost to the population, with the momentum now appearing to shift in Russia’s favour. Near neighbours are rearming, a NATO rethink is on the cards and Europe appears to be edging towards a coordinated defence policy involving the UK – which will be costly. Political strife in Germany and France has especially not been welcome – proportional representation has assisted extreme parties to enter the political mainstream, something that is less likely to happen here. Relations between the EU and the US are heading south and a trade war needs to be averted. Highish energy prices and Chinese manufacturing have also been testing, with German car manufacturers in particular feeling the heat in both cases. Germany has been in recession in recent years and the economic mood more widely has been sombre.
The potential
Poor sentiment has impacted company valuations. Yet there comes a point when most, if not all, of the bad news is in the price – when sentiment is near rock bottom. Recent figures suggest the MSCI Europe index is now trading at a near-record 40% discount to US stocks on a forward price/earnings ratio (not dissimilar to that of the UK). This leaves investors with a decent margin of safety, while recognising that such entry points are a key determinant of returns over time once sentiment improves. And here, regardless of little or no evidence of fundamental reform in the EU, the omens for corporate Europe are beginning to look up and markets are beginning to stir.
My column last month (‘Smaller companies are due their time in the sun’, 21 February 2025) highlighted why the lavish valuations afforded the larger US companies and the resulting ‘concentration effect’ signalled flashing lights. It is not that one doubts the potential of AI, the opportunities and challenges alike, but rather that valuations still matter. There is a lack of clarity as to just how profitable AI will be – a lot of hope is in the price. Meanwhile, the companies involved are slowly transitioning from being cash-generative businesses to ones which are now having to invest vast sums of money, in part to ensure they are competitively positioned. Recent estimates suggest some of Magnificent Seven are spending up to a quarter of their revenue on this endeavour. Valuations usually adjust for increased risk.
And straws in the wind suggest sentiment may be changing. The apparent success of the much cheaper AI model created by the Chinese company DeepSeek has concerned investors. What has been noticeable of late is that setbacks for this select group, whether caused by DeepSeek or not, have been met with resilience by other, cheaper sectors and markets. It suggests investors are beginning to seek better risk-adjusted returns, perhaps fueled by concerns about their lack of equity diversification. History suggests now is the time to pivot away, before it becomes a crowded trade, and the ETF trade kicks in. If anything, it is better to be a little too early, than too late – the recent relatively modest US setback may have further to go.
Meanwhile, things are beginning to look up for corporate Europe. Like the UK, it boasts many large multinationals which serve the global economy – with over half of revenue originating from outside Europe. The German top-flight companies comprising the DAX derive only c.20% of their sales from the domestic economy. And market ratings do not fully give justice to the changing composition of stock markets over the last few decades. A preponderance of telecoms and banks has made room for other fast-growing sectors such as healthcare, technology, consumer discretionary and industrials. Recent figures suggest this latter group has increased its share of the MSCI Europe (ex UK) index from c.35% at the start of the last decade to c.55% today.
This may help explain why the market’s return on equity has risen by 30% over the same period. And the earnings outlook is also looking better. After solid growth in 2024, Deutsche Bank is pencilling in double-digit growth this year, helped by technology stocks. This is part of the rationale when talking about the dangers of market concentration. Forecasts suggest more European than US companies will achieve double-digit earnings growth over 2025. It is perhaps no coincidence that other, better-valued markets including Europe have been making the running so far this year. Why wouldn’t investors question whether the difference in market valuations can be justified, while providing greater resilience over time should a US setback take hold?
Furthermore, while politics has tested sentiment in the past, investors should not underestimate the recent shift in German politics. Among a raft of proposals, the incoming Chancellor Merz has promised to relax the country’s ‘debt break’ – which has reflected the country’s cautious psyche as to borrowing, an understandable hangover from the Weimar Republic years and that which followed. Political negotiations across the political spectrum are apace, with the far-right AfD (which has 152 seats in the new parliament) already opposed. However, if successful, this should boost economic growth given Germany’s relatively small debt burden and allow significantly higher spending on defence and infrastructure.
The scale of this proposed increase in spending – for example, a 500bn euro infrastructure fund is being muted – may over time provide a strong tailwind to corporate earnings more widely. A faster growing Germany could help to bring about a step-change in Europe’s corporate growth outlook. Time will tell. Meanwhile, other straws in the wind bode well. For example, at a time the unpredictability of President Trumps’ policies may come to hamper the US, one of Europe’s biggest trading partners – China – appears to be stimulating its economy again. Of course, little of this may come about, but then there is little by way of expectation reflected in market valuations – unlike elsewhere.
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