After underperforming US stocks for most of 2021, European equities started the new year on firmer ground, with surging global bond yields sparking a rotation out of the growth-heavy MSCI USA and into the value-rich MSCI Europe. Below, we spell out why we think it may finally be time for European equities to shine.
The euro area will likely benefit from an accommodative monetary and fiscal policy mix at a time when policy elsewhere is being tightened. We think the ECB will continue expanding its balance sheet in 2022 and is unlikely to hike rates until mid-20231. But we expect the Fed to raise interest rates roughly five times this year and, starting in Q3, to engage in quantitative tightening.
Fiscal policy is also likely to be more supportive in the euro-zone. We estimate that the impulse from fiscal policy in Europe will remain expansionary in 2022 as Recovery Fund disbursements begin. By contrast, after negotiations on the Build Back Better Act stalled late last year, a pullback in fiscal support in the US looks inevitable.
Divergent policy in these economies should ensure that liquidity in Europe remains lush and financial conditions stay favorable for at least another year.
European equities offer an interesting mix of cyclical exposure and secular growth. That will be important as inflation replaces deflation as a key risk and a world of quantitative easing gives way to one of quantitative tightening. We expect this shift to support some further re-rating of value sectors in the market over the next year or so.
The MSCI Europe’s high concentration of cyclical sectors (~75% according to MSCI’s classification) and value-style stocks (>50%) lead us to believe these indices may do well in this environment. Historically European equities have delivered positive returns when the Fed hikes rates. This has been particularly so once the Fed has begun on a steady and gradual hiking process.
On average, the MSCI Europe returned 16% annualized during Fed hiking cycles (see Figure 1), which is well above the 6% average annual return of the past 20 years. This seems to be mainly a function of the European indices’ high concentration of stocks less sensitive to interest rate moves.
Source: Bloomberg, Datastream, Haver Analytics, Kenneth French, Goldman Sachs Global Investment Research, and Goldman Sachs Asset Management. Chart Notes: As of January 19, 2022. Data since 1970s or since available. For illustrative purposes only. Past performance does not guarantee future results, which may vary.
European stocks are also very sensitive to global growth dynamics. European companies generate roughly 60% of their revenues from abroad, which compares with just 30% for US firms2. Given our view that 2022 will deliver another year of above-trend growth, with economies outside of the US expected to narrow the gap, we believe European equities are set to benefit from this catch-up in growth differentials.
Looking beyond 2022, we believe that innovation will remain the main driver of equity markets in the post-pandemic cycle. But in a world that will be shaped by the concurrent revolutions in digitalisation and decarbonisation, we think that returns will be less bifurcated by sectors and factors than in the past. Investors should look for emerging companies in new areas of technology as drivers of growth as well as new companies and incumbents using technology to transform business models in industries outside of the technology sector.
We think the changes to the sectoral composition of European equities over the past decade (Figure 2 illustrates this for the MSCI Europe) make them uniquely positioned to benefit from the broadening of the digital revolution across industries and the increased focus and spending on decarbonisation. The short-term re-rating in value stocks as economies continue to reopen and rising interest rates put pressure on longer duration stocks should also benefit European equities.
Source: Bloomberg and Goldman Sachs Asset Management. As of November 30, 2021. 2007 data as of December 31, 2007. 2021 data as of December 31, 2021. The sectors included were based off the Global Industry Classification Standard (GIGS) and were chosen to highlight the change in growth-style sectors and value-style sectors. Not all sectors in the GIGS are shown. For illustrative purposes only. Past performance does not guarantee future results, which may vary.
The result, in our view, may turn out to be increased earnings convergence between US and European stocks. So as alpha becomes more important in a lower-return and higher-risk environment, investors may benefit from having the widest opportunity set possible and not limiting investments to the US.
Until recently, record-low interest rates meant that equities still represented relative value despite historically high valuations. But with front-end interest rates set to rise rapidly in the next couple of years, relative valuations are going to be an increasingly important consideration when investing, as high multiples often lead to lower future returns.
Figure 3 illustrates how valuations in Europe, as measured by the 12-month forward PE ratios, are much lower than those in the US. This is largely due to differences in the sectoral compositions of the two stock markets. Ever-lower bond yields have boosted the valuation of longer-duration equities in sectors such as technology at the expense of shorter-duration equities like value stocks over the past 10 years. The result: extremely low valuations in markets like Europe that are heavily weighted toward cyclical or traditional value industries and high valuation in technology-heavy markets like the US.
But even after adjusting for the differences in sectoral composition, valuation gaps between the two markets remain significant. This suggests that, while the US equity market should still perform well, there is more room for rising valuations, on a relative basis, outside of the US. We think that European equities offer attractive value, particularly for investors trying to reduce exposure to the most expensive areas of the market.
Source: Bloomberg and Goldman Sachs Asset Management. As of February 2, 2022. For illustrative purposes only. Past performance does not guarantee future results, which may vary.
As we illustrated in our “Market Minute: Thoughts on Recent Market Volatility,” rising interest rates are generally not an outright negative for equity markets. The crucial variable is economic growth. And while volatility has increased, we don’t think the current and prospective fundamentals are consistent with a recession within the next 12 months. In other words, we believe equities will make progress this year.
The recent value rotation points to potential benefits from a larger allocation to European equities. In fact, we think the accommodative policy outlook, beneficial sectoral composition and compelling valuations mean the opportunity cost of not investing in European equities today is higher than ever.
1 Goldman Sachs Asset Management, as of February 2022. The economic and market forecasts presented herein are for informational purposes as of the date of this presentation. There can be no assurance that the forecasts will be achieved. Please see additional disclosures at the end of this presentation.
2 Based on Stoxx Europe 600 and S&P 500 companies. As of December 2021.
This financial promotion is provided by Goldman Sachs Bank Europe SE. This material is provided for educational purposes only and should not be construed as investment advice or an offer or solicitation to buy or sell securities.