Europe’s Economy Is Rebounding. Here’s How to Play It.
Global investors have had little love for Europe in the past decade. Anemic economic growth, negative benchmark interest rates, and social and political challenges have kept a lid on European stocks, which have underperformed the technology-led U.S. market as well as markets in China and other dynamic emerging economies. Yet, the near-term case for relative outperformance by Europe now is the strongest in years. A postpandemic rebound could be followed by a new era of policy support for the Old World’s economy, creating near-ideal conditions for its equity markets.
The region’s most immediate economic catalyst is the emergence from the Covid-19 pandemic. Vaccinations in Europe have trailed those in the U.S., and stricter virus-related limits on mobility and economic activity are still in place. But some European countries are pulling ahead of the U.S. in first vaccine doses and rapidly closing the gap in second ones.
This sets up the region for looser restrictions in the second half of 2021, and a rebound in hiring, spending, and economic activity, much like America is enjoying today. U.S. gross domestic product grew at a 6.4% annualized rate in the first quarter, while Europe’s GDP shrank at a 0.4% pace. Capital Economics’ group chief economist, Neil Shearing, expects U.S. GDP to top its prepandemic level in mid-2021, a year ahead of the euro-zone economy. Europe is one of the few developed regions in the world in which some economists expect to see better GDP gains in 2022 than in 2021.
Photograph by Jessica Pettway
“Investors have played the reopening theme in the U.S. with a lot of success,” says Graham Secker, Morgan Stanley’s chief European equity strategist. “Now, there’s a general feeling that most of the good news about the U.S. economy is behind us, rather than ahead of us, and that growth momentum is peaking, whereas Europe is earlier in the cycle, and relative economic news flow is going to start to move in Europe’s favor.”
The near-term fiscal and monetary policy outlook is relatively more positive for markets there, as well. While attention in the States has turned to the Federal Reserve’s eventual tapering of bond purchases and potentially sooner-than-expected interest-rate increases, the European Central Bank isn’t likely to move in that direction for some time. And the European Union’s largest-ever stimulus package hasn’t even begun to be distributed, while the bulk of fiscal support in the U.S. and China is in the rearview mirror.
Investors feeling valuation vertigo can also find cheaper stocks in Europe, where indexes trade at marked discounts to their American peers. The pan-Europe Stoxx Europe 600 fetches 16.5 times 2022 estimated earnings, versus the S&P 500’s price/earnings multiple of 20.4.
Some of the discrepancy relates to U.S. indexes’ greater tilt toward growth companies and richly valued technology giants. But Europe’s discount extends to a sector-weight comparison, as well, according to Secker. Greater exposure to more-value-oriented and cyclically sensitive sectors, such as industrials, banks, and materials, should bode well for European indexes as the region’s economy rebounds.
“If you want exposure to the global recovery, Europe is a good catch-up play,” says Burns McKinney, senior portfolio manager of the Virtus NFJ International Value fund (ticker: AFJAX). “As an investor, you want to look for places where there’s room for improvement.”
None of this means that investors should expect a mammoth rally in European shares, which have already bounced off their 2020 lows, and then some. The Stoxx 600 is up 14% this year and trading just below its June record high, as is Germany’s DAX index. But the most optimistic analysts and market strategists think that European equities could gain another 10% or so.
What happens beyond Europe’s initial Covid-recovery bounce depends largely on the actions that fiscal-policy makers take as the economic cycle begins to age. Already in the works is the roughly 800 billion euro ($950 billion) NextGenerationEU recovery fund, which includes loans, grants, and contributions to existing programs across the European Union’s 27 member states. A greater share will go to those hit hardest by the pandemic—mostly southern European nations relatively heavily reliant on tourism, such as Spain, Greece, and Italy.
The recovery fund will be financed with bonds issued by the entire European Union, not individual countries, and due through 2058. This is a major step toward greater fiscal integration, something that previously had been fiercely opposed by some countries, mostly in Europe’s north. They historically have taken better care of their sovereign finances than their more profligate neighbors to the south, which German and Dutch voters long balked at bailing out. It took a sovereign debt crisis, Brexit, and a pandemic to bring European leaders to an agreement on jointly financed economic stimulus. “The post-financial-crisis period highlighted the glaring weakness of having a common currency and economic union without a real fiscal union,” says Abhay Deshpande, chief investment officer at Centerstone Investors. “Fiscal integration has been the big missing piece.”
The agreement also recognizes that, after seven years of subzero benchmark interest rates, there is only so much that the European Central Bank can do. As in the U.S., fiscal policy now is taking the baton.
The recovery fund kicks in this month, with spending targeted toward green energy, digitization, and other infrastructure investments across the EU through 2027. This is a pronounced contrast to what happened in the years following the global financial crisis a decade ago, when fiscal-austerity measures across the Continent hampered growth, economists say. This time around, the fund should lend support to an economic recovery for several years.
Political developments in Germany, where the Greens appear in a strong position ahead of a September election, and Italy—where Prime Minister and former ECB President Mario Draghi is pushing for domestic reforms and a multiyear investment program—could open the door to additional fiscal largess. And the European Commission is reviewing the framework under which EU member states are subject to certain budget-deficit caps or debt-to-GDP ratios. That could further reduce the impulse toward austerity whenever Europe crosses over to the other side of the pandemic. Higher post-Covid sovereign debt loads appear to be a worry for another day.
Finally, the ECB is publishing the results of its own monetary-policy review this September. While it is unlikely to be groundbreaking, it should directionally follow the Federal Reserve’s shift last summer away from a strict impulse to get ahead of rising inflation. It could include a move to a symmetric inflation target around 2%, up from the ECB’s current aim of tolerating inflation “below, but close to, 2%.”
The postpandemic policy regime in Europe could keep supporting growth long after the crisis has passed, be more tolerant of the economy running hot, and be better at targeting support for countries that need it. That could mean faster growth prospects and higher earnings priced into European stocks.
“It’s this confluence of political and policy factors that makes the next 12 months an incredibly important inflection point structurally,” says Rebecca Patterson, director of investment research at Bridgewater Associates. “Whether the currently very constructive picture for European markets is lasting or not will depend in large part on the outcome of these different events.”
That’s the macro case for investing in the region, and one that could give investors greater comfort about increasing their exposure to Europe in the coming years. Secker notes that European equities are relatively underowned, with fund flows largely negative, dating back to even a few years before the pandemic, a period in which the U.S. and emerging market stocks saw record inflows.
The Vanguard FTSE Europe exchange-traded fund (VGK) and iShares Core MSCI Europe ETF (IEUR) both provide broad exposure to the Continent’s stocks. Travel, energy, and other sectors hit hard by the pandemic also offer opportunities.
Fraport (FRA.Germany) operates Frankfurt’s airport, Europe’s fourth-busiest in pre-Covid 2019. It’s the largest holding in Deshpande’s Centerstone International fund (CSIAX). He points to management’s cost-saving measures during the pandemic, and argues that not all of the expenses will come back as travel volumes return to normal, setting Fraport up to earn more than it was making before the pandemic. Its shares have retraced about half of their losses since early last year. (For more on Fraport, see “European Tourism Is Ready for a New Trip. These Two Stocks Are Worth Taking Along.”)
Irish Continental Group (IR5B.Ireland) is another play on a travel rebound in Europe, as countries loosen restrictions and people get moving again. The company operates passenger ferry service on routes connecting ports in Ireland, Wales, and France, where there isn’t much competition. Irish Continental had been making significant capital investments to improve the speed, capacity, and comfort of its vessels when Covid hit, and has yet to reap the benefits of that spending.
“You’ve got a situation where, as passengers come back, they’ll see really substantial earnings leverage in the business,” says Jonathan Moog, chief investment officer and portfolio manager at Lizard Investors, an international small- and mid-cap investor.
Moog estimates that Irish Continental currently trades for about six or seven times normalized earnings before interest, taxes, depreciation, and amortization, or Ebitda, while ferry businesses normally go for 15 or 16 times.
There are also ways to play a European travel recovery from outside the bloc. Online travel site Booking Holdings (BKNG) gets the majority of its profits from the Continent. Its earnings fell during the pandemic as travel ground to a halt, but are poised for a rebound, says Matthew McLennan, who co-heads the $50 billion First Eagle Global (SGENX) and $15 billion First Eagle Overseas (SGOVX) funds. Booking is outspending its competitors on marketing, gaining share, and building adjacent businesses in experiences and home-sharing, all while benefiting from the industrywide growth of online travel agencies.
“When they come out on the other side, they should be earning more than they earned before the pandemic,” McLennan says. “The next peak in earnings should be higher than the prior.”
McLennan’s co-manager, Kimball Brooker, points to an under-the-radar pick: Groupe Bruxelles Lambert (GBLB.Belgium). The family-controlled holding company has stakes in several businesses across industries, including sportswear giant Adidas (ADS.Germany), liquor company Pernod Ricard (RI.France), and Swiss cement and concrete maker Holcim (HOLN.Switzerland). Brooker estimates that GBL stock trades for a roughly 20% discount to the value of its holdings.
“It’s an interesting way to participate in a collection of listed and private European companies,” says Brooker. “They’re strong businesses.”
GBL pays a dividend from the yields of its shareholdings, and management has been buying back stock to take advantage of the discount.
Relative bargains abound in the European banking sector, where stocks tend to trade below book value and at single-digit multiples of earnings. That compares with closer to two times book and earnings multiples in the low teens in the U.S. But some of the discounts are deserved, as European banks generally have higher leverage and lower profit margins than many U.S. institutions.
Brooker likes Sweden’s Svenska Handelsbanken (SHBA.Sweden), with its strong domestic market share. Virtus NJF’s McKinney sees value in global giant BNP Paribas (BNP.France), which trades at a discount to its peers and should benefit from a recovery in Europe. Rand Wrighton, who manages the $1.8 billion non-U.S. value equity strategy at Barrow Hanley Global Investors, points to ING Groep (ING) for similar reasons. Svenska Handelsbanken yields 4.2%; BNP Paribas, 2.1%; and ING, 2.2%. Higher shareholder returns should be in store later this year as the companies raise dividends and buy back stock, much as their U.S. counterparts plan to do.
Wrighton says that Europe’s most interesting group is its defense industry, including BAE Systems (BA.UK), Rheinmetall (RHM.Germany), and Thales (HO.France). The stocks sold off during the pandemic, but haven’t recovered as much as their North American rivals, leaving them with cheaper relative valuations and more attractive dividend yields. With tensions with Russia on the rise and NATO members under pressure to meet spending commitments, Wrighton sees European policy makers moving toward larger defense budgets.
“I’m not predicting an arms race, but a normalization,” says Wrighton. “The European defense apparatus is where the U.S. was in 2000, before it was built back up after 9/11.”
Another potential beneficiary of future increases in European government spending is Schneider Electric (SU.France). It makes components of electric grids, building and data-center power systems, and more. But the long-term growth potential is in its software unit, which is working on industrial automation. “It’s misclassified as an Old World industrial, when it fits more into a new-world software theme,” says McKinney. “It should trade at a premium to industrial-conglomerate peers.”
Smart investors are always looking to skate to where the puck is going, and for most of the past year—and decade—that has been the U.S. Even if America’s markets continue to rally, Europe deserves more attention. Its stocks are attractively valued, and the Continent’s economic prospects are brighter than in the past. That, plus the potential for favorable longer-term structural shifts, should be more than enough to awaken investors’ interest.