Morgan Stanley
  • Thoughts on the Market
  • Jan 8, 2021

Are the Clouds Clearing for European Equities?

Andrew Sheets and Graham Secker


Andrew Sheets: Welcome to Thoughts in the Market, I'm Andrew Sheets, Chief Cross-Asset strategist for Morgan Stanley.

Graham Secker: And I'm Graham Secker, Head of the European and UK Equity Strategy Team. 

Sheets: And today on the podcast, we'll be discussing the 2021 outlook for equity markets across Europe and how investors can view the region amid a global recovery. It's Friday, January 8th, at 3 p.m. in London.

Sheets So, Graham, before getting to what's in store for this year, we should mention 2020, where many stock markets rose, European stocks fell by double digits, a reason that I think sentiment towards Europe is still so skeptical. What do you think happened?

Secker: Yeah, Andrew. So I'd have to put the blame the door of COVID. I think, COVID hit Europe harder than elsewhere. Not necessarily, I'm not talking about terms of the number of infections per say, but rather in terms of the hit to the economy and corporate profits of European companies. You know, for example, if I look at the euro area economy in terms of GDP, it contracted by about 7% in 2020. That is more than double the fall that we saw in the U.S. economy or the global economy. And if actually if we look to the UK, the decline was even worse. The UK economy looks like it had the biggest hit to GDP of any major economy in the world, down around 11 percent. We think European earnings fell by around 30 percent or more last year. That is approximately twice the decline that we saw in the U.S. or Japan. And actually, in emerging markets, the earnings fall appears to be single digit, only. So, when we view, you know, when viewed through this lens, the underperformance of Europe last year actually seems pretty logical. It underperformed in line with weaker growth.

Sheets: And so then turning to the future, what do you think this year holds in store for Europe? And how do you think the market gets there?

Secker: Yeah, so this year we think is a is a much-improved year. So Europe struggled with COVID, as I discussed, in 2020. We think hopefully it can be one of the beneficiaries of the bounce back this year.. When we published our outlook report back at the beginning of November, we had around 11% upside in price terms for European equities, which was the highest of any of the major regions we were modeling at Morgan Stanley. Post the rally, since then, that number's come down and it's currently 5% upside to our index target. But we do have to include dividends there, which are going to give you another 3 or 4%. So we think you have high single digit returns on European equities for 2021. And just as a footnote, that is actually better at this point as well than the other regions based on my colleagues forecasts for the U.S. and Japan and emerging markets, etc. And I just want to make the point as well that policy support should be very accommodative with the ECB continuing to have a very large quantitative easing program and that should keep valuations underpinned as well. So a strong earnings recovery with valuations supported by central bank activity.

Sheets: So, Graham, you mentioned there the performance of other regions. And certainly one thing I hear a lot is that, look, you know, Morgan Stanley is forecasting pretty good emerging market growth next year. So why shouldn't I just buy emerging market stocks and forget about Europe? I imagine you've encountered the same sentiment. And how do you think about that dynamic?

Secker: Yeah, absolutely. And certainly emerging markets has performed better than Europe over the last few years. So it's sort of there's a natural sort of indication for people to go back to what has worked before. But one of the points that I would make is the starting point matters. If I look back over the last 12 months, emerging markets have already outperformed Europe by 20% and are now at a seven year high, i.e., if you look at the relative performance of the MSCI Emerging Markets Index to that of the MSCI Europe Index, it's at a seven year high in price terms and it's also at a seven year high in relative valuation terms as well. So that sort of positive outlook for emerging markets has already been discounted to some extent. I think the other point and what gets me interested in Europe for 2021 is this idea of Morgan Stanley's global reflation narrative. That's the story that you've touched on with some of our other speakers in the past. And I think Europe's more positively exposed to that than, say, emerging markets. I'll give you an example. If you look back over the last five years, if you look at which regions have performed best in periods when bond yields are rising and inflation is going up and it's actually been Europe, it's been Europe and Japan. And actually the U.S. and emerging markets have been regions that have tended to do better when bond yields have been falling rather than when bond yields have been rising. And I think that one last point there would be that Europe is predominantly a value index, which likes reflation and higher yields, whereas emerging markets these days has a lot of tech in it. So it's more of a growth index.

And, you know, Europe basically has quite a lot of banks and quite a lot of what I call cyclical value stocks. These are the areas of the market that tend to do best when yields are rising, it's much more helpful there than if Europe had a heavy sort of exposure to the tech sector, where arguably that would be more problematic. The other point I'd just make is when we think about the prospect of rising interest rates and bond yields around the world, it's just much harder to see bond yields rising very much in Europe than, say, the U.S. Therefore, we have to worry less about the idea that bond yields go up too much and start to weigh on equity valuations. So bond yields, whereas we think they can rise in Europe, the idea that they're going to rise strongly is much harder to see in Europe than, say, somewhere else like the U.S.

Sheets: Another knock, I would say, against Europe is that, you know, investors look at it and say, look, it's just not a region with the most exciting companies. You know, in other regions, you've seen more innovative, you know, more high growth, more kind of exciting technological development oriented companies and when you think about kind of what  are the most exciting stories in Europe, how do you think about that question and how do you think about the lack of kind of, quote, technology stocks within the European index as either being a strike against the region or actually maybe a supportive factor?

Secker: Yeah, look, it's a very pertinent question, because if you look back over the course of the last decade, Europe has been a fairly persistent underperformer. And I think a significant part of that is its sector composition. It has certainly if you go back 10 years, a lot of banks, a lot of oil companies that have had a very tough time over the last decade and, you know, not a lot of technology companies. What's interesting today is that the weighting of the market to banks and commodities is now much lower than it used to be. The unfortunate aspect of this, though, is that the weighting in technology, while it's gone up quite a bit, is far below what you would see in the U.S. or emerging market indices. the three largest sectors in Europe now are actually consumer staples, healthcare and industrials and there are sectors where I think that there are plenty of good quality companies. The other interesting angle within Europe is its ESG profile. ESG is, as I'm sure you're aware, is becoming an increasingly important part of investing. And European companies have basically been earlier on the ESG adoption than a lot of their global peers. And so when we look at the various stock market indices around the world, in aggregate, Europe actually has a better ESG score than some of these other regions. And potentially with the change of leadership in the U.S. and a bit more of a focus on ESG issues more broadly as we go forward, it could be that that angle for Europe is a big definite tick in the positive side of the ledger.

Sheets: So, Graham, finally, let's end with the U.K. Over four and a half years after voting to leave the European Union, there's finally a deal. How much do you think Brexit uncertainty weighed on the UK equity market? And what's most compelling in the UK from here as you look ahead into 2021?

Secker: Yeah, I think Brexit uncertainty has definitely weighed on investor sentiment towards UK equities and UK assets generally over the course of the last few years. And the good news is we've avoided a further negative outcome with a no deal. And I think there's quite an interesting opportunity with the FTSE 100 index. This is the main sort of bellwether index for the UK, although it isn't actually very UK centric. It's actually a very global index. We think this is an interesting story. We have considerably more upside for our FTSE target than we do our European equities target in the moment and is basically driven by two factors. Firstly, the FTSE 100 index is the cheapest major global stock market index that we can see today. It's much cheaper than the S&P or the TOPIX or emerging markets or even continental Europe. So the starting point is attractive valuations. Secondly, the earnings recovery in the UK for the FTSE in particular, should be stronger in 21 than elsewhere because they fell by more in 2020. And then thirdly, when you look at the companies that make up this index, there's quite a lot of financials and commodity stocks. And again, they're what we call sort of value sectors and they're very positively disposed towards this idea of global reflation and with higher yields and higher inflation.

Sheets: Graham, thanks for taking the time to talk.

Secker: Great speaking with you, Andrew.

Sheets: As a reminder, if you enjoy thoughts on the market, please take a moment to rate and reviews on the Apple podcast app. It helps more people find the show. 

Why a reflationary backdrop in 2021 could provide a boost to Europe’s cyclical value stocks. A look at the year ahead with Graham Secker, Head of the European and UK Equity Strategy Team.

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