Europe’s moment

Key takeaways:

• Three tailwinds benefiting European equities
• Investors should consider increasing their allocations to European equities

Despite the admonishments of most experts, for most of the past decade investors have done best avoiding international markets. That said, there have been periods when it has paid to venture overseas. Today, investors should consider increasing their allocation to European equities. European stocks are benefiting from three tailwinds: a drop in energy prices, cheaper valuations, and greater exposure to China’s reopening.

Beginning with energy, investors were rightly concerned that a war in Ukraine would usher in a lasting energy shock. Instead, a global slowdown and an exceptionally mild winter have conspired to lower energy prices. A proxy for U.K. natural gas prices is down 50% from its December peak and more than 85% from the August high. While Europe is still more vulnerable to an energy shock, the situation is vastly improved.

European equities are also benefiting from cheaper valuations. At 17.5x forward earnings, U.S. valuations are closer to average than cheap (see Chart 1). In contrast, most European markets are not only much cheaper than the U.S. but are trading at a significant discount to their long-term average. The Euro Stoxx 50 is valued at approximately 12.5x forward earnings, while the FTSE 100 is valued at just over 10x earnings.

While the difference in valuation can in part be attributed to different sector composition - more tech and fewer materials, industrial and financials in the U.S - the reality is European stocks, even on a sector neutral basis, are cheaper. Apart from earnings multiples, Europe also offers more income. Dividend yields in Europe and the UK are a percentage point or two above the U.S.

Finally, there is China. In the near term the Chinese economy is benefiting from a rapid reopening and supportive policy. According to Bloomberg, the median survey of economists now expects Chinese growth of 5.0% in 2023. And while many investors remain cautious on Chinese equities given uncertainty around regulation and economic decoupling, Europe offers an alternative way to benefit from improving Chinese growth. Several segments of the European economy, from French luxury goods to German industrials, directly benefit from China’s reopening.

International markets have had a tough slog for a very long time. According to Bloomberg, during the past decade the total return for the S&P 500 has been roughly 220%. The return on international developed markets has been approximately 65%, while emerging markets have posted a dismal 20% return. This huge differential reflects the success of the U.S. corporate sector in churning out record profits, and this advantage has not gone away. That said, every so often cheaper valuation and a shift in relative prospects creates an opportunity. Today, European equities look set to enjoy one of those periods of superior performance.

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