Comeback for Europe’s Bull Market?

Europe's equity rally has surprised many investors. Our Europe Head of Research Product Paul Walsh and Chief European Equity Strategist Marina Zavolock discuss potential outcomes of the broadening market.

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Paul Walsh: Welcome to Thoughts on the Market. I'm Paul Walsh, Morgan Stanley's Head of Research Products here in Europe.

Marina Zavolock: And I'm Marina Zavolock, Chief European Equity Strategist.

Paul Walsh: And today, we're looking at whether European equities have more room to broaden – as markets assess the implications of a potential U.S.-Iran deal and a reopening of the Strait of Hormuz.

It's Monday, June the 29th at 10am in London.

Marina, it's always great having you on. And for our listeners out there, I think they'd be interested to hear that if we look at Europe's performance year-to-date, it's now on a par to the S&P. So, both indices are up somewhere between 7 and 8 percent year-to-date. So, Europe is starting to stage something of a comeback from the conflict lows.

And so, what's driving this? And are we beginning to see inflows into Europe again?

Marina Zavolock: So, I'm going to give a two-part answer to this.

Firstly, Europe has a lot of the same exposure as the U.S., so that is part of the reason… I know that Europe has this kind of reputation for not having a lot of tech exposure; but we do have tech exposure…

Paul Walsh: We do.

Marina Zavolock: Not to the same degree as the U.S., but, let me just give you some numbers here.

So, we have a number of sectors heavily exposed to the AI CapEx boom. These are led primarily by the semis sector in Europe, tech hardware, cap goods, and metals and mining; specifically, copper has a link to AI as well. And those sectors, let's say roughly they make up at this point about 15 percent weight of our index. And if you look at that year-to-date performance that's on par with the U.S., almost 90 percent of it is made up from these sectors.

Paul Walsh: Yes.

Marina Zavolock: So, these sectors have moved just as aggressively as many of the AI pockets within the U.S. That's the answer that's kind of similar to the U.S. The answer that's a bit different is that we get from time to time, over the years actually, but we had a very big one earlier this year. We get these waves of interest in Europe because investors start to think about diversification. So…

Paul Walsh: That’s right. The broadening.

Marina Zavolock: Yes. So, they... And we've called for broadening recently on the back of this, Iran-U.S. MOU. But this broadening has other drivers as well. So when we felt this wave of interest in diversification, and we saw the flows coming into Europe earlier this year, the driver was initially because the Mag7 was kind of going choppy and sideways. So, that just drove diversification out of Mag7 and into equal-weighted S&P, but that also always benefits Europe. Or tends to benefit Europe.

But also, we had this wave of interest in real assets earlier this year; and Europe has a higher share of real assets than the U.S. Now, at this moment, I am sensing that we are getting that pickup in broadening interest once again from my feedback with investors.

You had this MOU, which was the initial trigger. You have oil prices, broadly, they're falling. That's helpful as well. But I think the biggest driver of what's driving this diversification interest at this moment is actually the volatility that we're seeing in the AI complex.

Paul Walsh: Mm.

Marina Zavolock: So, what a lot of the feedback I'm getting these days from investors that are coming back to Europe after focusing primarily on the U.S. is, ‘Look, I have a lot of AI in my portfolio. I like my AI exposure. I'm not looking to get rid of it or to sell it, but incrementally, I'm a little bit worried about this volatility. And I'm looking to broaden my exposure. What do you like in Europe to help me diversify away from this kind of volatility that we're seeing now?’

Paul Walsh: And I think that's a great segue, Marina, to my second question, because with Europe having really kept pace with the S&P year-to-date, the question that really is going to be asked is the sustainability of that relative performance. And when we think about a backdrop here in Europe of pretty low economic growth, the market continues to be worried about rate hikes given recent inflationary dynamics.

And as you've articulated there, tech has played a very significant role here in Europe as well in terms of driving markets higher. So, you've alluded to it in a few of your comments already, but how sustainable do we see this as being?

Marina Zavolock: It depends on AI, to be honest with you. So, if AI starts to really move up at an aggressive pace like it was earlier this year, then it's hard for Europe to outperform given our exposure. But if that starts to move up at a more moderate pace, Europe has a chance to do very well.

Paul Walsh: Mm.

Marina Zavolock: I think there's a lot of misperceptions when it comes to European equities. And outside of AI, actually there's quite a lot of strength. So, misperception one, you've mentioned it, which is basically: Oh, look at our PMIs, look at our GDP growth. Why bother with European equities? I think this is maybe what some U.S. investors may think.

But just like in the U.S., the equities market, and maybe even more so, the equities market in Europe – it is not the economy.

Paul Walsh: Mm.

Marina Zavolock: So, we just published our global exposure guide over this past weekend, which Morgan Stanley has been running 29 iterations of this guide.

Europe's exposure to Europe is pretty much at historical lows over decades. Europe's exposure to Europe as a percent of revenues is now 45 percent of revenues …

Paul Walsh: Yeah.

Marina Zavolock: ... is European exposed. The rest is very global, including the U.S. Um, Europe, uh, Of that 45 percent domestic, a lot of that is banks, some defensive sectors. Only a very small sliver is actually consumer-oriented sectors that would see earnings downgrades on the back of ECB hiking, for example. So, I think people may also be surprised to know that consensus earnings growth for Europe this year is over 16 percent.

Paul Walsh: Mm.

Marina Zavolock: It's really healthy.

Paul Walsh: It’s pretty healthy.

Marina Zavolock: I know the U.S. is over 20, but Europe is over 16 percent. These kinds of ideas of, you know – we have a shortage of energy and therefore our earnings are going to be down – they're misperceptions. Because actually, as long as oil doesn't spike to, I don't know, [$]150. If it stays within a healthy range, call it [$]70 to 90, that's actually a very good environment for Europe because we have a lot of real assets.

We have the banks which benefit from higher inflation because they trade on the steepness of the curve. And we have some AI exposure. If you add up those three things, which all benefit from inflation, that's 60 percent of our earnings pie.

Paul Walsh: Right.

Marina Zavolock: Hence, Europe's actually doing really well. And I'll just mention one other thing. Earlier this year, we broke out of a structural downtrend discount; that range that we were trading in versus the U.S. So, for almost 10 years, Europe's discount was just going wider and wider and wider and wider. And as of January 1st, this year, on a like-for-like basis, so sector neutral excluding Mag7, we broke out of that structural downtrend, and we keep seeing a narrowing.

Paul Walsh: Yeah.

Marina Zavolock: So, if you're going to broaden, it actually makes a lot of sense to look at Europe, where we have these discounts, and we have value, and we have growth.

Paul Walsh: Yeah. So, the point there being the relative valuation discount of Europe to the U.S. has been actually closing a little bit more recently. Final question from my side.

You have obviously recently refreshed your sector model. We have talked about the broadening in our conversation today. What are you advocating to your clients out there in terms of relative sector preferences?

Marina Zavolock: Yeah. So, we run a data-driven model. Just briefly, we look at things like earnings revisions breadth – works really well as a leading indicator in Europe; a leading indicator for future earnings as well.

Consensus price target revisions breadth, balance sheet measures. We look at a number of different things, AI exposure. And basically, I'll just give you the top sectors in our model now. Semis number one, metals and mining number two, led by copper.

Paul Walsh: Mm-hmm.

Marina Zavolock: Banks number three. I think banks, for me, it's a key diversification play.

Paul Walsh: Yes.

Marina Zavolock: A big differentiator. And trading on 10 times PE with very high distributions, buybacks and dividends, low teens earnings growth upgrades. Front of the line on AI adoption and seeing that ROI coming through. Cap goods, number four, that's also led by AI exposure.

Paul Walsh: Yeah.

Marina Zavolock: And then I'll just mention lastly, utilities is an overweight as well. That's also a little bit AI linked, but very, very under-owned; lagging the trends we've seen in the U.S. And broader based in terms of the positives there because we also have this drive for renewables, which is coming back.

Paul Walsh: Marina, always, we value your insights highly. Thanks as always for taking the time to talk.

Marina Zavolock: Great speaking with you, Paul.

Paul Walsh: And thanks for listening. If you enjoy Thoughts on the Market, please leave us a review wherever you listen. And please do share the podcast with a friend or colleague today.