Europe has surprised everyone

Bearish forecasts for the European economy - and equity market - haven't come to pass
Anthony Doyle

Firetrail Investments

Economists are increasingly getting more bullish on Europe. Most have taken out recession forecasts for 2023. Not only has the economic data surprised, the hard data suggests a 25% probability of recession versus around 60% in October.

There are a number of reasons for optimism. Supply chains are unclogging. The equivalent of 2.5% of GDP in fiscal stimulus went to households to help offset higher energy/food costs, acting as a temporary boost to growth. Gas prices have collapsed and energy rationing risk appears off the table this winter.  We are also seeing an unusual divergence in economic surprise indices between Europe and the US, with European data surprising to the high side of economists expectations.

European economic data has surprised to the high side of expectations

The equity market has responded. European equities have posted a record start to the year of a +12% (local) price return which has been led by cyclicals. After 48 weeks of outflows from European equity funds, last week saw the first inflow. 

Increasingly, investors are questioning whether 2023 will be the year that European equities outperform US equities after more than a decade of relative underperformance.

The signs are good. Europe's outperformance relative to the US may have further to go especially in a soft-landing scenario. The market's valuation is cheaper (13x vs 18x 12m forward p/e). According to Goldman Sachs, accounting for the different sector weights of each market, Europe still trades at a large discount.

Europe trades at a large discount to the US. Source: Goldman Sachs

Another tailwind for European equities has been the improvement in earnings. This is this mainly due to the brighter outlook for Value sectors such as Commodities and Financials which managed to improve their margins with higher commodities and rates while Growth stocks and Tech seems to have lost momentum.

Europe's total yield (buybacks and dividends) is above the US for the first time in 30 years. There has been a record increase in European buyback activity, with a net buyback of EUR220bn creating an additional yield of 2%.

It is also important to note with most investors looking east at the potential upside risk to earnings from a faster recovery in China, 16% of European company revenues come from the US, versus just 8% for China – i.e. the US is twice as important as China for European corporates in aggregate. 

In the Firetrail S3 Global Opportunities Fund (Managed Fund) (ASX: S3GO), we are finding excellent companies that have the ability to grow earnings in the current environment. These include Royal KPN, Schneider Electric and Air Liquide. The fund currently has a 5.7% overweight to European companies relative to the MSCI World Index. 

European equities outperforming the US was definitely a contrarian call, but there are tentative signs that it could continue in 2023. Regardless, we believe that companies that have sustainable business models, delivering sustainable earnings, and contributing to sustainable change are the best opportunities in an uncertain macro environment.

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This communication was prepared by Firetrail Investments Pty Limited (ABN 98 622 377 913, AFSL 516821) (Firetrail). It is for general information only. It has been prepared without taking account of any person’s objectives, financial situation or needs. It is not intended as a securities recommendation or statement of opinion intended to influence a person or persons in making a decision in relation to investment. Any persons relying on this information should obtain professional advice before doing so.

1 fund mentioned

Anthony Doyle
Head of Investment Strategy - Firetrail S3 Global Opportunities Fund
Firetrail Investments

Anthony Doyle is Head of Investment Strategy for the Firetrail S3 Global Opportunities Fund. His primary responsibilities include fundamental idea generation, portfolio analysis, and economic insights including currency and macroeconomic risk...

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