The strong start for European equities in 2023 – and consequent underperformance of the previously reliable US market – has wrongfooted many investors. Cosy consensus is this is a short-term phenomenon and that normal service will resume in due course.
This is presumably comforting to many investors now most have recently moved to global benchmarks, which in reality, of course, means having more than half a portfolio’s capital exposed to the US stock market.
But if we learn one lesson the hard way as investors, it’s that Mr Market has a nasty habit of upending comfortable, conventional wisdom.
We only have to look at the underperformance of the growth style from mid-2021 for a very recent example where the best advice to investors heavily exposed to, say, FAANG stocks was, “panic early”.
We would argue the conditions are now in place for this advice to once again be pertinent, albeit this time from a geographical perspective. The parallels of value vs growth and Europe vs US are clear.
One observation is that European equities are as cheap as they have ever been relative to global (really, US) benchmarks. Seemingly ‘twas ever thus, of course, but the fact is that the weight of European equities in a global benchmark has halved over the past 15 years.
Just as the ‘value’ in value stocks led to violent outperformance once the catalyst of higher inflation and higher rates became apparent, causing severe damage to undiversified portfolios, so the relative value within European equites will be problematic if pro-European catalysts come to pass. Timing is difficult, but when contrarianism works, it really works.
And this is where things get really interesting. Europe’s problems of course haven’t gone away overnight, of course. But it is probable that this next cycle is going to look a lot better than the crisis-addled, post-global financial crisis period.
There are a number of reasons for this. In a sticky inflationary cycle – unlike the previous deflationary one – the US is going to have more difficulty controlling than Europe will, given it has structural labour shortages.
From a demand perspective Europe has discovered the folly of austerity and fiscal policy is a now a structural tailwind. When governments are half an economy, as they are in Europe, that really matters.
Then we have the ability to export our energy saving and green technologies globally for which there is increasing demand. Devastatingly, Ukraine is a huge country of 44 million people and needs rebuilding, which will take a continent-wide effort. And real wage growth will probably be positive by the end of the year.
Finally, despite the headlines, a decade of structural reforms – both monetary and fiscal – mean that the black swan crisis risk is reduced.
However important these factors are, though, there really is one simple argument which calls for a reassessment of the huge overweighting to the US.
The most recent cycle – and the investment regime we have just ended – overwhelmingly favoured something the US is very good at: Big Tech. The ability of, say, Amazon in a smartphone enabled and quantitative easing, zero-rate world, to amass billons of revenue in countries from across the planet and turn it into American shareholder value is the predominant reason why just 4% of the global population now ‘owns’ 60% of the global stockmarket.
The same is true of Uber, Netflix, Google, Facebook… and the list goes on in each of their respective industries. Big Tech, as we know, drove the US outperformance. But regulators are coming, and anyway these are such huge companies now that their ability to double again is severely curtailed by their size.
Can 4% of the population own 80% (or even stay at 60%) of the global market without causing a geopolitical backlash? This seems unlikely: the cracks are appearing already.
If Big Tech has had its day what is going to count – and many would argue actually needs to dominate the next cycle – is the decarbonisation of society. Where it lags at Big Tech, Europe is brilliant at Green Tech. We’ve done it longer, better and cleaner than anywhere else.
‘Green’ capital investment needs to be no less than a vast $6trn per year to Europe’s benefit. As these industries get the positive demand shock we are all praying for – the demand shock which means we are decarbonising the world – their valuations can soar. The cycle will belong to Europe.
At that point investors who paid heed to Mr Market’s message in early 2023 will be pleased indeed they did so.
James Sym is head of equities at River & Mercantile. The views expressed above should not be taken as investment advice.