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6 min read

A trip to Europe

Like many European teams at the World Cup, European markets have been underperforming. However, just as it would be unwise to bet against soccer giants like Germany and Italy in the long run, we see upsides to the European markets and believe our investment process and philosophy provides a strong foundation for long-term returns.

By CWB Wealth Investment Team
  • European underperformance
  • Discounting risks
  • Upsides on the horizon

European markets, like many European teams at the World Cup, have been underperforming. Yet, just as it would be unwise to bet against traditional European soccer powerhouses in the long run, we see upsides to the European markets.

When travelling to Europe, one of the things that really stands out is the vibrancy of its culture. Europe receives more visitors than any other region in the world due to the rich cultural heritage and diversity it offers: historical landmarks, architecture, street festivals, food, music, beaches, views, and the list goes on. Unfortunately, this vibrancy has not correlated into European stock markets as Europe has tended to be an underperformer relative to the rest of the world for quite some time.

With the 2022 FIFA Soccer World Cup currently underway, one can’t help but draw parallels between one of the world’s premier sporting competitions and the markets. European teams dominated the latest FIFA rankings coming into the tournament: seven out of the top 10 seeded teams were European, including Belgium, France, Italy and Spain. (It’s eight if we include England.) Germany was not far behind, ranking as the 11th best team globally.

Expectations for the European teams at the start of the tournament were elevated. Yet, as we sit here in early December, the reality has turned out slightly different. Italy, winners of four World Cups, failed to even qualify for this World Cup despite winning the UEFA Euro 2020 tournament. Similarly, multiple top seeded European nations failed to advance to the knockout stages, with Germany and Belgium amongst notable countries leaving Qatar surprisingly early. Likewise, Spain failed to advance past the Round of 16 after losing to a high-spirited Morocco.

However, it would be unwise to bet against teams like Italy, Spain and Germany making a comeback in the future. European nations have won four out of the five World Cups held since the start of the 21st century. Bolstered by a number of well-established grassroots foundations, Europe continually produces and attracts some of the world’s best players, teams and managers. Can another World Cup win for Europe be far away?

What is in the Price?
The relative underperformance of European markets earlier this year has not been unwarranted. Investors have been faced with unique economic and political uncertainties particular to the region, in addition to rising global inflationary and interest-rate risks stemming from the Russia-Ukraine war.

Chief among these uncertainties has been the continent’s historical reliance on Russian gas. As Russia cut off gas supplies to its European customers, investors rightly became concerned about the wide ranging direct and indirect implications of such a move. Among other things, these implications affect power and electricity markets and prices, as well as the European chemical sector where gas is an important input. These all have knock-on effects on other sectors and end consumers.

As investors, we pay attention to headline risks but also broader market expectations that can have an important impact on future returns. One of the key tenets of our investment philosophy is valuation, leading to the important question: “What is built into the price?” Stock markets are a discounting mechanism, and at any point in time the market can over-discount certain risks and vice versa.

In our view, for all the uncertainty that Europe faces, investors are discounting unrealistic levels of pessimism making the market inexpensive relative to other markets. As an example, according to Redburn (a European-based research firm), based on current valuations, European equities are implying negative growth in returns on capital employed (Figure 1).

Figure 1: Implied future growth in returns based on current stock market levels (U.S. vs Europe)
Implied future growth in returns based on current stock market levels (U.S. vs Europe)

Source: Redburn

However, if the implied growth in returns of capital employed for European markets was to normalize to the 30-year average Europe would see an upside of 65%. This compares to a 5% upside in the U.S. markets, on average, using a similar exercise. Such relative outperformance would not be a completely new frontier for European equities, which outperformed their global counterparts for over 20 years starting in the mid 1980’s.

Overall, expectations for European markets are more negative that at any point over the past 30 years, a period which included events such as the European Debt Crisis in 2009/2010. This does not seem reasonable or rational to us. Elevated and unrealistic expectations can lead to lower returns and vice versa.

This is not to say that the risks in Europe have dissipated. However, current valuation levels seem to be more than discounting the economic and political risks the continent faces. They do not appear to give any credit to Europe for managing such risks. For instance, in the short term, Europe has over delivered on gas storage levels (to counteract the impact of Russian gas deliveries or lack thereof) compared to expectations earlier in the year. According to the latest data, the average gas storage filling level among member states was over 90%. The agreed minimum EU target was 80%.

90.6% of EU gas storage is filled

Source: Reuters

Outlook
In addition to depressed expectations and valuation levels, Europe will be challenged to keep up with the green energy transition, which is accelerating. Europe needs to do all it can to increase its energy independence. Europe’s ambitious plan will require capital investment in areas such as renewable energy development, which should be positive for economic growth. European companies are also key exporters to China, one the world’s fastest growing economies to 2030. In our opinion, all these factors set up a healthy outlook for Europe.

Our investment process focusses on what is in our control and predictable. This includes investing in businesses with sustainable competitive advantages, proven management teams, appropriate balance sheets, and valuations that represent a discount to the value levels we believe the company should be, and will be, at. “Black swan” or unpredictable events, such as the Russia-Ukraine war, can cause pain in the short term. But similar to soccer giants like Germany and Italy, we believe our investment process and philosophy provides a strong foundation for long-term returns.

Sources: Redburn, Reuters and Fifa

Information presented herein is for discussion and illustrative purposes only and is not a recommendation or an offer or solicitation to buy or sell any securities. Views expressed are as of the date indicated, based on the information available at that time, and may change based on market and other conditions. Unless otherwise noted, the opinions provided are those of the authors and not necessarily those of CWB Wealth or its affiliates. CWB Wealth does not assume any duty to update any of the information. Investment decisions should be based on an individual’s own goals, time horizon, and tolerance for risk. Nothing in this content should be considered to be legal or tax advice and you are encouraged to consult your own lawyer, accountant or other advisor before making any financial decision. Quoted yields should not be construed as an amount an investor would receive from the Fund and are subject to change. Investors should consult their financial advisor before making a decision as to whether mutual funds are a suitable investment for them. Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments.

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