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- [00:01]
A
Welcome to Thoughts on the Market. I'm Paul Walsh, Morgan Stanley's head of research product here in Europe.
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And I'm Marina Zavolok, chief European Equity strategist.
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And today we're looking at whether European equities have more room to broaden as markets assess the implications of a potential U S Iran deal and a reopening of the Strait of Hormuz. It's Monday, June 29th at 10am in London. Marina, it's always great having you on and for our listeners out there, I think they'd be interested to hear that if we look at Europe's performance year to date, it's now on a par to the S and P. So both indices are up somewhere between 7 and 8% year to date. So Europe is starting to stage something of a comeback from the conflict lows. And so what's driving this and are we beginning to see inflows into Europe again?
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So I'm going to give a two part answer to this. Firstly, Europe has a lot of the same exposure as the US so that is part of the reason. I know that Europe has this kind of reputation for not having a lot of tech exposure, but we do have tech exposure, not to the same degree as the U.S. but let me just give you some numbers here. So we have a number of sectors heavily exposed to the AI Capex boom. These are led primarily by the semis sector in Europe, tech, hardware, cap goods and metals and mining specifically, specifically copper has a link to AI as well. And those sectors, let's say roughly they make up at this point about 15% weight of our index. And if you look at that year to date performance that's on par with the US almost 90% of it is made up from these sectors.
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Yes.
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So these sectors have moved just as aggressively as many of the AI pockets within the us. That's the answer that's kind of similar to the US the answer that's a bit different is that we get from time to time over the years actually. But we had a very big one earlier this year. We get these waves of interest in Europe because investors start to think about diversification.
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So the broadening.
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Yes, so they, they and we've called for broadening recently on the back of this Iran US MoU. But, but this broadening has other drivers as well. So when we felt this wave of interest and diversification and we saw the flows coming into Europe earlier this year, the driver was init because the Mag 7 was kind of going choppy and sideways. So that just drove diversification out of MAG7 and into equal weighted S and P. But that also always benefits Europe or tends to benefit Europe. But also we had this wave of interest in real assets earlier this year, and Europe has a higher share of real assets than the U.S. now, at this moment, I am sensing that we are getting that pickup in broadening interest once again. From my feedback with investors, you had this MoU, which was the initial trigger. You have, you have oil prices, broadly, they're falling. That's, that's helpful as well. But I think the biggest driver of what's driving this diversification interest at this moment is actually the volatility that we're seeing in the AI complex. So what I what a lot of the feedback I'm getting these days from investors that are coming back to Europe after focusing primarily on the US is look, I have a lot of AI in my portfolio. I like my AI exposure. I'm not looking to get rid of it or to sell it, but incrementally I'm a little bit worried about this volatility and I'm looking to broaden my exposure. What do you like in Europe to help me diversify away from this kind of volatility that we're seeing now?
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And I think that's a great segue. Marina, to my second question, because with Europe having really kept pace with the S and P year to date, the question that really is going to be asked is the sustainability of that relative performance. And when we think about a backdrop here in Europe of pretty low economic growth, the market continues to be worried about rate hikes, given recent inflationary dynamics. And as you've articulated there, tech has played a very significant role here in Europe as well in terms of driving markets higher. So you've alluded to it in a few of your comments already, but how sustainable do we see this as being?
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It depends on AI, to be honest with you. So if AI starts to really move up at an aggressive pace like it was earlier this year, then it's hard for Europe to outperform, given our exposure. But if that starts to move up at a more moderate pace, Europe has a chance to do very well. I think there's a lot of misperceptions when it comes to European equities. And outside of AI, actually, there's quite a lot of strength. So misperception one, you've mentioned it, which is basically, oh, look at our pmi, look at our GDP growth, why bother with European equities? I think this is maybe what some US investors may think, but just like in the US the equities market, and maybe even more so, the equities market in Europe, it is not the economy. So we just published our global exposure guide over this past weekend, which Morgan Stanley has been running 29 iterations of this guide. Europe's exposure to Europe is pretty much at historical lows over decades. Europe's exposure to Europe as a percent of revenues is now 45% of revenues is European exposed. The rest is very global, including the US of that 45% domestic, a lot of that is banks, some defensive sectors, only a very small sliver is actually consumer oriented sectors that would see earnings downgrades on the back of ECB hiking, for example. So I think people may also be surprised to know that consensus earnings growth for Europe this year is over 16%. It's really healthy. I know the US is over 20, but Europe is over 16%. These kinds of ideas of we have a shortage of energy and therefore our earnings are going to be down, they're misperceptions because actually as long as oil doesn't spike to, I don't know, 150, if it stays within a healthy range, call it 70 to 90. That's actually a very good environment for Europe because we have a lot of real assets. We have the banks which benefit from higher inflation because they trade on the steepness of the curve. And we have some AI exposure. If you add up those three things which all benefit from inflation, that's 60% of our earnings pie.
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Right.
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Hence Europe's actually doing really well. And I'll just mention one other thing. Earlier this year we broke out of a structural downtrend discount, that range that we were trading in versus the U.S. so for, for almost 10 years, Europe's discount was just going wider and wider and wider and wider. And as of January 1st this year, on a like for like basis. So sector neutral, excluding max 7, we broke out of that structural downtrend and we keep seeing a narrowing. So if you're going to broaden, it actually makes a lot of sense to look at Europe where we have these discounts and we have value and we have growth.
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A
Yeah. So the point there being the relative valuation discount of Europe to the US has been actually closing a little bit more recently. Final question from my side. You have obviously recently refreshed your sector model. We have talked about the broadening in our conversation today. What are you advocating to your clients out there in terms of relative sector preferences?
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Yeah, so we run a data driven model. Just briefly, we look at things like earnings revisions breadth works really well as a leading indicator in Europe, a leading indicator for future earnings as well. Consensus, price target, revisions, breadth, balance sheet measures. We look at a number of different things, AI exposure and basically I'll just give you the top sectors in our model now. Semis number one metals and mining number two led by copper Banks number three I think banks for me it's a key diversification play. Yes, a big differentiator and trading on 10 times PE with very high distributions, buybacks and dividends, low teens, earnings growth, upgrades, front of the line on AI adoption and seeing that ROI coming through Cap goods number four that's also led by AI exposure. And then I'll just mention lastly Utilities is an overweight as well. That's also a little bit AI linked but very very under owned. Lagging the trends we've seen in the US and broader base in terms of the positives there because we also have this drive for renewables which is coming back.
- [08:35]
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Marina, as always, we value your insights highly. Thanks as always for taking the time to talk. Great speaking with you Paul and thanks for listening. If you enjoy thoughts on the market, please leave us a review wherever you listen and please do share the podcast with a friend or colleague today.
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