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European Equities Outlook
Investment in Europe

European Equities Outlook

Investors should look for companies with sustainable debt levels that generate cash and can self-fund growth.
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20 APR, 2023

By Donny Kranson

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Investors’ concerns around recession, rising energy costs, rising inflation, China’s protracted lockdown, and conflict in Ukraine, eased in the first quarter of 2023, until the threat of a banking crisis appeared in March. Nevertheless, the improving sentiment helped push European equities higher from a relatively low base. 

The rebound from low valuations is a one-time benefit for European stocks. Longer-term equity performance is tied to earnings growth, and European growth remains structurally low. However, for the selective investor, there are enough high-quality European companies that can grow despite a slow growth backdrop. 

Regulators’ quick response to the banking crisis helped calm markets, and the European banking system is much stronger than it was before the Global Financial Crisis. Low and negative rates were bound to create challenges when reversed. The market cheered higher rates, but issues around non-performing loans and unhedged rate exposure were overlooked. While we cannot know where all of the problems are, we expect to see more development as the misallocation of capital was more widespread than the banks currently affected. Financing for banks will also be more difficult due to the Swiss regulator’s decision not to protect holders of AT1 debt instruments. 

Investors should look for companies with sustainable debt levels that generate cash and can self-fund growth. Companies that are unproven and unprofitable should see a squeeze, as will the real estate market given rising interest rates. Green projects should continue to attract capital thanks in part to available government funds.

We remain cautious on businesses in energy, materials, and banks, which we generally do not consider high quality. However, we do act on opportunities, such as UBS’s takeover of Credit Suisse, which enabled it to acquire its rival at an attractive price – even with assumed losses. While there could be surprises in the future, we expect the result will strengthen UBS’s wealth management business.

We are overweight industrials but avoid capital-intensive, highly cyclical businesses. Instead, we focus on companies with structural growth and little correlation to the macro environment, such as RELX and Wolters Kluwer, which are exposed to data management and analytics, or Vinci and Rentokil, which offer services needed in any economic environment. 

Inflation appears to be rolling over or at least topping out in many countries. The banking crisis and assumed tightening of lending may change the peak rate and trajectory, but we expect rates to continue to move higher. While high inflation is relatively uncommon in Europe, other regions have experienced it recently. Most multinationals, particularly in the consumer space, have the experience and playbooks to respond. 

Some business costs, including energy and transportation, are beginning to ease, which will be helpful to companies. The reductions will unlikely help earnings in 2023 as most companies are hedged. Instead, we expect the benefits to start to come through in 2024 earnings.

We believe companies that offer unique but necessary products and services, and that have the capacity to raise prices in line with inflation, will continue to do well in a tough economic environment. Companies that sell luxury goods and cater to wealthy individuals should also be protected, as in recent recessions. We expect healthcare companies that offer treatments and services not tied to the economy to perform relatively strongly, and businesses operating with long lead times, for instance in the technology space, should also be somewhat insulated.

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