The surprise performer of 2023 – Will sentiment ever change for European equities?

If investors ignore the tech-driven distortions of the US market, and the transitory charms of a couple of emerging markets, a surprising sector bubbles to the top of the performance league tables in 2023: Europe. Funds in the Europe ex UK sector have outpaced even fashionable Japan year-to-date*, while UK and Asian funds have been left trailing far behind.

The relative strength of European funds is particularly noteworthy when it is set against the economic backdrop for the region. While Eurozone inflation appears to be under control – it hit 2.9% in October, its lowest level for two years** – the region’s overall economic performance has been grim.

The Eurozone economy contracted in the three months to September undershooting expectations***, and the latest business survey suggests that the outlook is worsening***. Unemployment is rising, with knock-on effects on consumer sentiment.

The Eurozone’s bellwether economy, Germany, continues to struggle. The country’s important manufacturing sector has been weakened by higher energy costs and productivity problems in its labour force****. German industrial production declined 3.7% in the year to September^. While it may deter the European Central Bank from further rate rises, and may even hasten cuts in 2024, it is a tough climate for companies to operate in.

Alexander Darwall, manager of the European Opportunities Trust, says: “The slowdown in the European economy is becoming more obvious, particularly in Germany. Companies reporting recently have noted demand weakness for the likes of crop protection, industrial specialties and food ingredients, 5G, luxury goods and electric vehicles. In the US, credit card spend in luxury continues to deteriorate.” (Europe is known for its luxury brands).

Samantha Gleave, co-manager of Liontrust European Dynamic, tells us more about the impact of recession in Germany in our recent podcast.  

With this in mind, the recent strength has certainly not come from any renewed optimism about the prospects for European companies. The MSCI Europe sits on a forward price to earnings ratio of 11.5x, versus 15.6x for the MSCI World^^. Although the MSCI Europe has outpaced the MSCI World over one year (5.4% versus 1.6%^^), this has come through stronger earnings, rather than any expansion in valuations. Essentially, sentiment towards Europe is still poor.

Earnings expectations are muted, Alexander adds: “Earnings expectations for European companies are coming down. Whereas in America recent results are tracking well, in Europe third quarter earnings are estimated to have contracted by 7%, though the figure is better excluding energy stocks.”

World class businesses

What explains the strength of many European funds?

Once again, it is a number of high quality companies, geared into powerful global trends and highly prized by investors across the world that have made the difference for investors. This might include ASML, for example, which is part of the semiconductor value chain for AI, or Novo Nordisk, which makes diabetes and weight loss drugs. Both are index heavy-weights, held widely in active portfolios, and have seen strong share price performance for the year-to-date.

Tom Lemaigre, manager of Janus Henderson European Selected Opportunities, says these are part of a raft of global champions within Europe that are really good at what they do. There is no global equivalent to luxury goods companies such as Hermes, or Luxottica, for example.

Similarly, Alexander has never been a cheerleader for European economic management, but also believes there are some world-class businesses to be found on its stock markets. He holds Genus, for example, a pioneering gene editing group, alongside French biotechnology group Biomerieux, plus software group Dassault Systemes and Deutsche Boerse.

These European companies are often tapped into strong structural trends. Tom points to areas such as energy efficiency and electrification, which are well-supported by government spending programmes, including Fit for 55 – a package by the European Union designed to reduce the European Union’s greenhouse gas emissions by 55% by 2030.

The Janus Henderson European Selected Opportunities portfolio holds companies such as Dublin-based diversified building materials group CRH, or Swiss multinational Holcim Group, which are both benefiting from US and Eurozone fiscal spending.

Lower valuations

In general, these companies are available at far lower valuations than their US equivalents. Tom says European markets naturally offer a margin of safety that just isn’t there in US markets. However, in European terms, these areas are still relatively expensive. Some of these companies also feature significantly in the major indices. The MSCI Europe has Novo Nordisk, Nestle, ASML, LVMH Moet Hennessy and Total Energies among its top 10 weightings^^.

While this may be the best place to focus while sentiment remains fragile, there may be a greater opportunity emerging in smaller companies. Alex Magni, manager of WS Montanaro European Income, which focuses on small and mid-cap European companies, says: “Small caps have had a tough period. They are now lagging large caps by 8% for the year to date, of which 6% was in the third quarter alone. It was the second worst quarter in over 13 years^^^.

“Yet from an operational perspective, the companies are broadly fine. They are doing what they say on the tin. We now find ourselves with small caps at near record low valuations compared to large caps.” He adds that small cap companies have underperformed large caps for around five years by an average of 3% per year^^^. The average European smaller companies fund is up just 1.3% for the year to date, compared to a rise of 8.9% for their large cap equivalents*.

Alex points out that small caps now offer a higher dividend yield as well. He has holdings in the portfolio such as asset management group Amundi, or construction group Kaufman & Broad, which have yields of over 8%. Normally, he says, this level of yield would be a red flag, but these businesses appear operationally sound and their dividends well-supported.

As with UK small caps, the difficulty is seeing what might turn the tide for European smaller companies. They may be cheap, but they are more domestically-focused at a time when European economies are flagging. It is plausible that a shift in interest rates turns the tide, in which case smaller companies could rally quickly.

In reality, the dilemma investors face in the European markets is little different to that seen across most markets today. The strongest companies have been large, high profile global champions that are tapped into global trends. These companies are cheap relative to similar companies in the US, but more expensive than the deeply unloved and unfashionable small and mid-cap names. When markets start to turn, there could be significant gains in beaten-up smaller companies, but in the meantime, Europe’s global leaders are a safer option.

*Source: FE fundinfo, sector performance, 1 January 2023 to 20 November 2023

**Source: Eurostat, 17 November 2023

***Source: Financial Times, October 2023

****Source: Financial Times, September 2023

^Source: Trading economics, November 2023

^^Source: MSCI index factsheet, 31 October 2023

^^^Source: Montanaro Asset Management, 25 October 2023