Why investor eyes are returning to Europe

This year has begun with turbulent markets and an equity decline led by US growth-oriented names, says Ritu Vohora (pictured), capital markets specialist at T. Rowe Price.

Whether it marks a bigger shift away from the innovative, high growth, tech names - which have dominated equity market performance in the last decade - remains to be seen.

The growth in this segment of the market has been driven by some truly innovative business successes, which have changed the way we live, work, shop and communicate.

But the stunning outperformance of a concentrated group of companies has led many to question when this strong run will slow down and whether valuations in other areas of the market are due a catch-up.

In this relatively recent, but prolonged, period of US tech dominance, European equity markets have lagged - despite having performed mostly in line with US markets in the preceding four decades.

Improved market landscape

Europe's underperformance over the last decade can be largely attributed to differences in sector composition, as well as sharply diverging performances by some of the largest companies on either side of the Atlantic.

At the start of the last decade, European markets were heavily skewed towards traditional, old economy sectors, such as financials and energy, which made up around a third of the MSCI Europe index.

Performance in this space was particularly lackluster in a period of slow economic growth. Meanwhile, tech and consumer discretionary made up the smallest segments.

Conversely, tech has been the largest sector in the S&P 500 over the past decade, with a handful of names - including Apple, Microsoft and Alphabet - dominating performance and delivering annualised returns of more than 30% over the period.

Fast forward to today, we have started to note a transition to a superior sector mix in Europe, with increasing exposure to sectors such as consumer discretionary, industrials and IT - offering opportunities across a broad market spectrum.

Notably, Europe has produced some world leading brands in consumer industries, such as luxury goods and automobiles, as well as in the pharmaceuticals and industrials sectors.

With 15 markets featuring in MSCI's developed Europe category, this can be a complex universe to navigate - given multiple languages and differing national social, political and legal structures.

However, it can also offer a diverse and compelling opportunity set.

European equity markets remain more skewed towards value- and cyclically-oriented sectors than the US.

This could prove advantageous in a recovering global economy and a rising rate environment, which can be challenging for longer duration assets.

This style bias also contributes to the higher average dividend yields typically offered by European stocks.

Europe's ESG advantage 

Globally, countries are increasingly aware of the need to encourage businesses to operate in a responsible way, improve practices, and come up with solutions for tackling environmental and social challenges.

But ESG has long been on the agenda for European investors, corporates, regulators and governments. A recent ISS ESG report determined that Europe remains the frontrunner in terms of sustainable finance regulation.

The regulatory environment in this space has stepped up a notch with the EU Taxonomy and Sustainable Finance Disclosure Regulation (SFDR).

This seeks to set a credible, best-in-class framework that is likely to set the standard for the rest of the world.

The EU's Fit for 55 set a target of reducing net greenhouse gas emissions by at least 55% by 2030, versus 1990 levels, and will align legislation with this goal.

The European Green Deal seeks to tackle climate change and environmental degradation and looks to improve the wellbeing of citizens in doing so, by also targeting areas such as the accessibility of healthy and affordable food, improved public transport and job resilience. 

Arguably ESG issues have been front of mind in Europe for longer and more consistently than elsewhere.

Companies may well be better prepared for the evolving corporate landscape and poised to benefit from greater investor focus on sustainability.

The heavy emphasis on sustainability in Europe could also provide a source of innovation and market leadership going forward.

Opportunities in reopening

As Europe emerges from the latest wave of the pandemic, easing of Covid-related restrictions could boost services such as hospitality and travel-related sectors, among others, providing selective opportunities for investors.

Pent-up savings from almost two years of on/off restrictions could also boost consumer spending, alongside stronger business investment.

Furthermore, the policy framework remains supportive, with accommodative monetary policy and unprecedented fiscal support from the €800bn NextGeneration EU economic recovery package - which aims to boost growth and aid investment in Europe's green transition, infrastructure and digitalisation agenda.

While risks around supply chain issues, inflation uncertainty, heightened geopolitical risk, US dollar strength and reduced demand from China are notable concerns - elevated risk premiums in Europe could help provide a buffer to global volatility.

Plus, Europe's cyclical orientation, supportive fiscal policy and relatively attractive valuations provide near-term support. As earnings recover - particularly in more value-oriented sectors - there is potential to outpace other regional markets.

The European universe is diverse and increasingly dynamic. The impact of the pandemic has not been even across all markets.

A focus on fundamentals is more important than ever, particularly given recent market volatility, which could provide an attractive entry point for selective opportunities.

Ritu Vohora is a capital markets specialist at T. Rowe Price