Darius McDermott: Are European equities finally turning the corner?

Europe has had many false dawns in the past decade or so having been blighted by both economic and political uncertainty. Investors voted with their feet, favouring the US instead.

There were some green shoots of hope for Europe at the start of 2020 as accommodative monetary policy, calming political tensions and strong underlying fundamentals (such as low levels of unemployment) promised better times ahead.

A few months later and the major outbreak of coronavirus in Italy - and its subsequent spreading across Europe and beyond - was a game changer. The discussion quickly changed to what type of recession Europe will face, in short those hopes of recovery never materialised.

Could it be different this time? There are a few reasons that suggest so. Figures from Morningstar show that there were positive flows into actively managed European equities in June - following 28 months of outflows.

One of the chief reasons is that Europe has, compared to others, been successful in managing the spread of the coronavirus. Europe began to ease lockdown measures with the likes of France, Spain and the Netherlands among the first to re-open shops and schools from mid-May - contrast this to the US where the number of cases and deaths continues to escalate.

According to a research note from Amundi, most European countries have already reinforced their healthcare systems and policies to fight a possible second wave, raising hopes that it is more likely to be contained compared to the initial outbreak.

Another positive is that in July, after days of intense negotiations, EU leaders finally reached a deal on a €750bn recovery package to reconstruct the region's pandemic-stricken economies. An agreement on the next seven-year budget, which will be worth over €1 trillion, was also reached.

The EU recovery plan will allow Brussels to borrow up to €750bn in the financial markets and hand it out as budgetary support to EU member states. This will be achieved by issuing a range of bonds, repayable by the end of 2058. The plan will include €390bn of grants (which will be distributed from 2021 to 2023) and €360bn of loans.

There is some scepticism as to whether the plan will work: consensus forecasts estimate that eurozone growth contracted 15% year-on-year during the second quarter of 2020, but the recovery fund is only expected to deliver a 6-7% boost - a boost that will not begin until the start of next year when the first grant is paid.

That said, the ability of the EU to reach this agreement in the first place has been seen as a huge positive and with Brexit firmly on the radar, it offers hope that we could avoid a hard exit and the disastrous repercussions that could bring.

Another boon for the market is the evolution of the key sectors underpinning it. For example, healthcare companies account for one sixth (16.5%) of the MSCI Europe index. Information technology is also growing within the index, while the likes of energy is falling.

Valuations for the region are also attractive when compared to the US. As of the end of June, the cyclically adjusted price-to-earnings ratio for Europe ex UK was 18.2x, compared to the US on 27.7x, according to Schroders.

GAM Star Continental European Equity fund manager Niall Gallagher says we are unequivocally returning to a growth phase, citing the fiscal policy response to prevent mass unemployment leading to a build-up in consumer savings. He says the sectors he expects to see a recovery in include the likes of autos, construction & building materials and certain areas of industrials. He is more cautious on travel-related sectors where recovery is likely to be more gradual. Overall, he is bullish on European equities, provided we do not have further lockdowns.

While we are by no means out of the woods, what this crisis has done is given active managers in Europe the opportunity to reinforce positions in companies that should be able to grow across all market conditions - given the wholesale sell-off and subsequent historic discounts we have seen.

Managed by David Walton and Will Searle, investors may want to consider a strong stockpickers' fund like the Marlborough European Multi-Cap offering. The fund offers access to much smaller companies than many of its peers, with the premise being these businesses are often overlooked and hence have the potential to outperform.

Other experienced active managers worth considering include John Bennett and Mark Nichols, who manage the Janus Henderson European Focus and Jupiter European fund respectively.

Darius McDermott is managing director FundCalibre

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