Staying the course: The value opportunity set in European markets

European stock markets have continued to climb this year. At the half-way stage, the MSCI Europe Index was up nearly 10% (total returns, in euros), following gains of around 16% in 2023. However, the positive headline result arguably doesn’t reflect the volatility that’s taken place in markets. There’s been lots going on below the surface that investors have had to navigate. 

A dominant issue that investors have wrestled with is the direction of interest rates. Since the start of the year, expectations for the number and pace of interest rate cuts have been scaled back significantly. In June, the European Central Bank (ECB) started cutting interest rates from record highs, but with inflation still above the central bank’s 2% target, there is uncertainty about the timing of future rate cuts. Was it ‘one and done’ for ECB rate cuts this year? 

“Since the start of the year, expectations for the number and pace of interest rate cuts have been scaled back significantly.”

In this global ‘year of elections’, investors have also contended with political risk. In June, following the result of the European Parliamentary elections, French President Emmanuel Macron announced snap parliamentary elections. This led French assets to fall sharply in value amid concerns about a potential victory for the far-right Rassemblement National (RN) and the country’s precarious fiscal position. Although the RN ultimately came third in the second round of voting, the outcome has arguably resulted in more uncertainty with a hung parliament and a potentially complicated coalition. 

Style factors have also been an influence this year. Globally the value style has lagged the broader market and growth stocks. However, in Europe, value’s underperformance has been more modest than in the US where the ‘Magnificent Seven’ mega-cap growth stocks have driven the market.

Change in perception towards banks

One traditional value sector that has done well in Europe this year is banks. At the beginning of the year, investors were rather cautious about banks because of concerns about the impact expected interest rate cuts would have on earnings. This view altered as the market reassessed the speed of rate cuts and what this might mean for earnings. We think this change in perception towards banks saw investors switch from avoiding banks to seeing them as attractively valued investments.

The banks sector, which is generally regarded as a classic value sector, is one of the best performing in Europe this year, only trailing information technology. In fact, since the start of 2021, European banks have outperformed the US technology-dominated Nasdaq Composite Index (in euro terms). We believe this supports our thesis, discussed below, that we are in a new investment regime where different stocks are likely to perform well.

Ongoing uncertainty

As we have seen, the first half of the year has been turbulent. Looking ahead, investors will need to continue navigating through uncertainty. For example, on the political front, risks remain elevated with the lack of clarification around the French election. The upcoming US election on 5 November is also likely to influence sentiment globally.

Meanwhile, the debate around where interest rates will settle is still not resolved. As a result of these factors, it seems that we are likely to experience plenty of market volatility ahead. This will be difficult, but it could also present opportunities for active investors, who can potentially take advantage of market dislocations and mispriced stocks.

The value opportunity: Europe’s two-tiered market

On a longer-term view, as dedicated value investors, we are excited about the value opportunity in European equities. Big imbalances have built up in the European market, where the valuation gap has now created what we describe as a two-tiered market.

Since we started our European Value Equity strategy in 2008, the gap between the cheapest and the most expensive stocks in the market has widened significantly. We believe this valuation dispersion is a manifestation of two factors: first, valuations of many quality growth stocks reached elevated levels during the zero-interest rate period. These stocks have also benefited from global and passive investors; they tend to focus on big, well-known European growth stocks such as Novo Nordisk, ASML, L’Oreal and Louis Vuitton and have arguably driven up already elevated valuations.

As a result, the cheaper part of the market has largely been overlooked and remains very attractively valued, in our view. With the valuation dispersion in Europe close to the widest ever levels, we believe there are promising opportunities at the value end of the market. The European market is also trading at a significant discount to the US market. In our view, this makes European value stocks a very attractive long-term opportunity, indeed.

The value opportunity: New investment regime

As well as attractive valuations, another reason for our optimism about the prospects of value stocks is that we believe we have moved into a new investment regime where many of the trends that dominated in previous years are coming to an end.

We think the market environment has changed from one of stability and predictability, where investors did very well without a consideration for valuations, to a world of volatility, disruption and surprises. In our view, this changeable backdrop will create opportunities for bottom-up, fundamental-based, patient value investors to identify stocks that are caught up unfairly in dislocations. We suggest valuations will become much more important in a time of increased volatility.

Recent examples of instability include the banking crisis in the US (and its subsequent contagion to Europe); macroeconomic worries; and the impact of rising bond yields on equity ‘bond proxies’. All of these have created opportunities for us as contrarian value investors. The first half of 2024 provided further support for this era of increased turbulence. We believe this world of unpredictability will persist, and being in a position to take advantage of mispriced stocks could lead to good alpha opportunities.

In a world where valuations of out-of-favour value stocks look attractive and the investment regime has different trends, we believe different stocks could do well in the years ahead compared to those which led the markets previously. Today’s value stock today may well be tomorrow’s growth stock.

The value of investments will fluctuate, which will cause prices to fall as well as rise and investors may not get back the original amount they invested. Past performance is not a guide to future performance. The views expressed in this document should not be taken as a recommendation, advice or forecast.