Global equities: Is Euro pessimism overdone?

Investor pessimism about a Continental recession seems overdone and European shares are starting to look good value, argues Pendal’s Paul Wild

• EU shares hit by war and energy crisis
• Value emerging
• Banks to benefit from rising rates

EUROPEAN shares are starting to look good value for investors willing to look through the Ukraine war and winter’s likely energy crisis, argues Pendal Group’s Paul Wild.

Companies in Europe are trading at an average of about 11 times next year’s earnings, which is around 20 per cent lower than the average price earnings ratio of the last few decades.

There is reason for the pessimism. The drawn-out Russia and Ukraine war shows no sign of resolution, and a looming energy crisis and potential power rationing is raising the risk of recession.

“The starting point is that investors are basically at maximum underweight for European equities,” says Wild, who manages a European equities fund at Pendal’s UK-based subsidiary J O Hambro.

“We’ve had about 30-plus weeks of outflows this year. Since 2016, investors have redeemed about 30 per cent of their holdings in European shares.”

For most investors, reducing euro holdings has been the right move.

European shares have underperformed US shares over the last 10 years, largely because the US economy has been growing faster and US market features more technology and other high-growth companies.

“But if you look at the decade before that, in local currency terms Europe and US performance was pretty similar,” says Wild.

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Growth stocks outperforming

“So the question is, can the growth stocks keep outperforming?”

That depend on the path of interest rates, says Wild.

“The growth boom benefited from the extrapolation of very low risk-free rates and negative real rates which had a massive effect on valuations.

“Coming into the Covid period, it almost felt as if valuation didn’t matter anymore.

“Now with interest rates going back up, valuation has become a hot topic again.

“That’s quite exciting and puts Europe in a good place. Why? Because on a global basis, Europe shares are slightly underweight growth and overweight value.”

One of the main reasons European markets overweight value is because of a heavy weighting to financials, with some of the world’s largest banks listed on the European exchanges.

“European banks have around €6 trillion of demand deposits which until recently yielded zero or lower. If the European Central Bank moves rates move north of 2 per cent, sector profitability will be transformed,” says Wild.

“The bottom line that you are starting to see already is very large earnings upgrades for European banks, simply on the back of net interest margin expansion.”

Wild says the trajectory of global interest rates favour Europe over the US, with the likely peak in cash rates in Europe likely to be nearly half the level of where the US peaks.

“Interest rates in Europe are rising but they are still going to be far lower than in other parts of the world.”

European recession fears ‘overdone’

Wild also says investor pessimism about recession is likely overdone, with the eurozone likely to skirt recession over the winter.

“Fiscal policy in Europe, particularly in Germany, is having a significant turn. Germany has come out with three aid packages since the Ukraine invasion which in total equate to about 2.7 per cent of GDP.

“Unemployment in Europe is still at all time low levels and we’re seeing reasonable consumer resilience.”

And importantly, the EU has also been aggressively building gas reserves to head off shortages over winter.

“It feels like European governments have taken away the Armageddon scenario,” says Wild.

The environment is ripe for a shift in investor approach back to GARP — buying ‘growth at a reasonable price’ — which suits Europe’s weighting towards industries like pharmaceuticals, automotive, insurance and banks.

“Who doesn’t like to buy growth? But it absolutely has to be at the right price.

“There are banks in Europe trading at five- or six-times earnings, yielding 7 or 8 per cent — with share buybacks.”

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About Paul Wild and Pendal global equities strategies

Paul Wild is senior fund manager with J O Hambro Capital Management, a London-based active investment manager which is part of Pendal Group.

Paul manages J O Hambro’s Continental European fund.

Pendal offers a range of global equities strategies to Australian investors including:

• Pendal Global Select Fund
• Pendal Concentrated Global Share Fund
• Regnan Global Equity Impact Solutions Fund
• Pendal Global Emerging Markets Opportunities Fund

Pendal is an independent, global investment management business focused on delivering superior investment returns for our clients through active management.

Contact a Pendal key account manager here