European equities performed well in 2021, but still lagged behind their US counterparts. A supportive pandemic and policy outlook should help to support earnings in the Euro Stoxx 600, as key Cyclical and Growth sectors should benefit from this cyclical upswing. Coupled with appealing valuations, we think that European equities still look attractive, especially when compared to US equities.

6th Jan 2022

  • Europe’s growth outlook remains strong despite a 5th wave of COVID-19. Cases have peaked, but economic data shows signs of turning, while pandemic data suggests Omicron may not be as severe as Delta.
  • ECB is likely to keep monetary policy relatively dovish. This is mainly due to relatively benign inflation, and we think ECB has more time to tighten policy compared to the US.
  • As a result, earnings should remain supported. We expect robust earnings growth in 2022 and 2023 due to a combination of domestic and global economic recovery. We also look at some sectors that could outperform the rest of the index.
  • Valuations remain appealing, with the Euro Stoxx 600’s P/E ratio slightly above its historical average but nothing too steep. In fact, valuations have dropped steadily since last year due to improving earnings. More notably, valuations are very appealing compared to the S&P 500, which now sees steep valuations.
  • With the growth and policy outlook remaining bright, we think that the Euro Stoxx 600 is well-placed for the economic recovery as it contains both Cyclical and Growth elements. We see an upside potential of 14% over the next 2 years and remain positive on European equities. Therefore, we maintain our 3.0 Stars “Attractive” rating on European equities.

European equities look set to finish 2021 strongly – apart from a weak 3Q21 performance, the Euro Stoxx 600 climbed over 5% each in 1Q21 and 2Q21, and should close off 4Q21 similarly (barring any sudden drawdowns). So far, the Euro Stoxx 600 has notched a very solid +21.7% YTD gain, outpacing Japanese equities (+4.5% YTD) but still lagging US equities (+27.6% YTD).

Chart 1: Performance of Developed Market Equities YTD

Looking ahead, we think that the outlook for European equities in 2022 remains attractive. In addition, given heightened risks in the US equities space highlighted in our previous article, we also believe that European equities look to be a wiser choice to gain exposure into Developed Markets.

Growth Outlook Remains Strong Despite 5th Wave

In recent weeks, Europe has been hit with a 5th wave of COVID-19 led by the Omicron variant. Case counts are peaking, particularly in major economies like Germany, France, and the UK. As a result, governments are potentially looking at the reinstatement of pandemic restrictions, which would adversely affect growth prospects (especially the retail sector over the Christmas / New Year season).

Chart 2: Number of COVID cases in Europe are peaking

Economic data shows positive signs

PMI figures have adjusted downwards this month. However, we note that Eurozone PMI figures remain solidly over 50 (Mfg: 58.0 / Svcs: 53.3), indicating that while growth momentum is easing from mid-2021, growth on the whole remains strong as both the manufacturing and services sectors have expanded every month since Apr 2021. Services PMI saw a much sharper decline in Dec – not entirely unexpected due to Omicron – with Germany’s Services PMI dipping below 50, but we think that it is still too early to turn negative on the Eurozone recovery, as economic data remains firmly positive.

Chart 3: Eurozone PMI figures remain solidly over 50

We would not be surprised if Omicron may lead to generally lower economic figures over the coming months, but we also note that despite worsening conditions, things may look worse than they seem. The Citi Economic Surprise Index shows the degree of data surprise increasing (after bottoming out in early Oct), and the index has actually turned positive this month, indicating that economic data on a whole has turned out stronger than market expectations. Coupled with preliminary findings suggesting Omicron to be less severe than Delta, and the fact that hospitalization and death rates are lower now (versus previous waves), we think there is a good chance that Europe (among other countries) can recover from this growth shock quickly.

Chart 4: Eurozone economic data is starting to surprise to the upside

High vaccination rates and decisive policymaking reduces growth risk

In addition, we think that Europe’s combination of high vaccination rates, and decisive policymaking, can help to tide Europe through this 5th wave of COVID-19.

  • High vaccination rates: On surface, Europe’s headline vaccination numbers look unimpressive at 61%. Compared to its DM counterparts, they are very slightly behind the US, and significantly behind Japan.  However, bearing in mind that the Euro Stoxx 600 has 50% of its allocation in France, Germany and UK combined, we can see that the headline figure actually understates the progress of vaccination in countries more relevant to the index, as the three regions mentioned have approximately 70% of their populations vaccinated (much higher than the headline 61%).
  • Decisive policymaking: Key European countries have shown their ability to respond quickly and decisively to this Omicron variant, as they take lessons from previous waves.
    • Germany has implemented “2G” restrictions since Nov, which are differentiated pandemic restrictions for those who are vaccinated or have recently recovered from COVID-19 (similar to VDS here in Singapore). France has recently announced fresh movement restrictions to begin in 2022 (e.g. mandatory WFH for at least 3 days of the week). UK did not implement any pandemic restrictions specifically over the Christmas / New Year break, though they already implemented a “Plan B” measure earlier in Dec.
    • Some European countries like Germany and France have also floated the idea of vaccine mandates. Though such a policy will inevitably see alot of pushback, we think that these countries are generally moving in the right direction in mitigating the effects of COVID-19.

Table 1: Key European countries have much higher vaccination rates than continent average

 Fully VaccinatedPartly VaccinatedTotal
Japan78%1%80%
France73%5%78%
Germany70%3%73%
UK69%6%76%
US61%12%73%
Europe61%4%65%
Source: Our World in Data. Data as of 27 Dec 2021.

Monetary Policy: ECB likely to remain relatively dovish

Economies across the world generally saw higher inflation in 2021, on the back of higher food and energy prices. While EM central banks generally led the way in tightening monetary policy in 2021, this trend appears to be moving towards DMs as well. The Fed is looking increasingly hawkish – in its latest dot plot in Dec 2021, Fed officials are now expecting 2 – 3 rate hikes in 2022 (up from about 1 – 2 hikes in the previous dot plot 3 months back).

 

In contrast, the ECB is likely to remain relatively dovish, especially when compared to the Fed, which should lead monetary policy among DMs. This is due to a combination of relatively benign inflation, as well as slower growth compared to the US.

Inflation looks relatively benign in Europe compared to US

Inflation in Europe has recently surged to record highs (4.9% YoY in Nov 2021) in the Eurozone, and ECB have also recently revised their official inflation projections upwards (3.2% in 2022 / 1.8% in 2023). Nonetheless, ECB president Lagarde appears to remain unconcerned, describing recent inflation readings as a “hump (that) eventually declines”. While we think there is a risk of “transitory” inflation being more permanent than expected (similar to Fed’s rhetoric over 2021), we note that Europe has traditionally lagged the US in inflation. Market consensus reinforces this view, forecasting Europe inflation to remain elevated (2.5% in 2022 and 2023) but still below that of the US.

Chart 5: EU inflation likely to remain lower than US inflation

ECB likely to remain relatively conservative

ECB remains relatively cautious on growth, and has frequently cited new Omicron variant and persistent supply-chain disruptions as risks to the downside. With this conservative take towards growth, and the aforementioned benign inflation outlook, ECB’s Lagarde has pledged to keep policy loose thus far. While the €1.85tn PEPP will end in Mar 2022 as planned, the ECB is keeping options open with a temporary doubling of the APP (from €20bn a month), as well as a pledge to re-invest cash from maturing bonds in PEPP (both PEPP and APP are ECB programmes designed to purchase assets from the market).

 

On the whole, we think ECB policy will likely remain more accommodative than the US in 2022. In the US, the Fed is working on a tight timeline with clear risks of policy missteps, as they need to (i) complete their asset-purchase taper, and; (ii) manage the 2 – 3 rate hikes implied by consensus as well as the official dot plot by end-2022. In Europe, due to the relatively lower growth and inflation numbers, the ECB is also not expected to hike rates anytime soon unlike the US. Based on market data (see table below), consensus expects a small 10bps rate hike by end-2022 for the Eurozone, much less than the Fed (+70.8 bps) and BoE (+104.3 bps). Therefore, ECB has a much longer timeframe in which they can conduct their monetary tightening (including rate hikes), and the relatively more gradual tightening compared to the US should prove to be more supportive of European asset prices.

Table 2: Expected change in policy rates (market-implied)

CountryCurrent Policy RateExpected Change in Policy Rates (bps)*
1M3M6M1Y2Y3Y
US0% – 0.25%1.012.335.270.8124.2128.3
Eurozone-0.50%0.00.02.39.641.251.6
UK0.25%6.028.262.5104.398.9100.8
Source: Bloomberg Finance L.P., iFAST compilations. Data as of 27 Dec 2021.
*Policy rates are estimated using forward swaps.

Earnings to remain strong in multiple sectors

We believe that the growth outlook remains constructive, as we expect the economy to recover well following the Omicron variant and monetary policy to remain accommodative. Market consensus also sees a strong economic recovery in the coming years (4.2% / 2.5% in 2022 / 2023 respectively). As a result, consensus estimates expect about 73% earnings growth in 2021, followed by high single-digit earnings growth in 2022 and 2023 each.

 

We agree with consensus that earnings are set for a strong rebound. European companies generally derive their revenue from a mix of domestic and international sources at an estimated split of 60% / 40% respectively for the Euro Stoxx 600, meaning that both domestic and global recoveries will generally be supportive of European equities. In addition, we note that European equities generally have a pro-cyclical tilt, with a higher allocation in sectors that do well during an economic recovery.

 

We think that cyclicals will continue to see strong growth in 2022. We now look at specific sectors, that we think can help support earnings for the overall Euro Stoxx 600, and ultimately support price performance as well.

Table 3: Euro Stoxx 600 is heavily weighted towards cyclicals

StyleSectorEuro Stoxx 600 Weight (%)Consensus EPS Growth (YoY, %)
202120222023
Cyclical(Weight: 69%)Industrials17%150%0%-18%
Financials16%39%-2%6%
Cons. Disc.12%920%96%14%
IT8%32%17%18%
Materials7%26%5%4%
Comms.5%14%3%8%
Energy4%186%7%-3%
Non-Cyclical(Weight: 31%)Health Care15%16%9%17%
Cons. Stap.10%33%17%10%
Utilities4%3%7%6%
Real Estate2%-2%8%7%
Source: Bloomberg Finance L.P., iFAST compilations, iFAST estimates.
Data as of 27 Dec 2021.

Consumer Products – leveraged to global economic growth and reopening

The overall Consumer Products sector is driven by the “Consumer Pdt. & Svcs” and “Food, Beverage & Tobacco” industries, which together account for 14% of the index. The sector saw strong earnings growth in 2021, particularly in the Consumer Discretionary segment. The economic recovery meant that consumers had more disposable income on hand to spend, and some pent-up demand on the back of periodic tightening and relaxation of pandemic measures, as well as the rise of online shopping.

 

Looking forward into 2022, we see the Consumer Discretionary sector rebounding strongly in the next few years, fueled by hopes that the world can overcome the pandemic once and for all.

  • The “Consumer Pdt. & Svcs” industry includes well known luxury brands like LVMH, Richemonte and Hermes – we think that the lifting of restrictions will help sales of these luxury brands. We are also mindful of a potential slowdown in China affecting consumer demand, though on the whole, global consumer demand should remain robust.
  • For the “Auto & Parts” industry, we note that 2021 already saw an outsized earnings performance, and therefore do not expect them to repeat the same performance in 2022 (given a high base). Nonetheless, we think that Auto companies can benefit from EU’s push towards a greener future, and tap on programmes offered by the EU (e.g.  30% of the EU’s €2tn NGEU budget will be dedicated to climate change). 
  • Another industry that will benefit is the “Travel & Leisure” industry, which is forecast to see triple-digit earnings growth in 2022. Once again, pandemic restrictions will play a big role in determining whether these earnings actually come to pass, though it will help that oil prices have recently corrected downwards.

Table 4: Consumer Products should see strong earnings growth

SectorIndustryEuro Stoxx 600 Weight (%)Consensus EPS Growth (YoY, %)
202120222023
Cons. Disc.Consumer Pdt. & Svcs7.0%91%15%12%
Auto & Parts2.5%979%8%10%
Retail1.1%61%10%9%
Travel & Leisure1.1%81%461%54%
Cons. Stap.Food, Beverage & Tobacco7.1%14%10%17%
Cons. Stap.Personal Care Drug & Grocery Stores2.7%5%8%7%
Source: Bloomberg Finance L.P., iFAST compilations, iFAST estimates.
Data as of 27 Dec 2021.

Financials – another sector with strong cyclical traits

We believe that the Financials sector is another sector that can leverage on the cyclical upswing. The Financials sector is mainly driven by the Banks, and Insurance industries. They saw very strong earnings growth in 2021, mainly due to one-off loan-loss provisions. Looking forward into 2022, while consensus sees negative earnings growth in some industries, we think these figures are skewed due to a high-base effect from a one-off event.

  • Financials typically have a strong beta to the economic recovery, as an economic recovery generally comes with more spending in the economy (especially on big-ticket items), which then leads to more lending from banks. The current rate-hike environment led by the Fed generally favours Financials, and can support it for the next few years.
  • European banks are in a good place at the moment. Unlike the GFC in the 2000s, and the Eurozone crisis in the 2010s, we have not seen any major bank collapses in Europe (and around the world) that could trigger a contagion effect from the Financials sector. Banks appear to be much more well-capitalised now, probably in part due to post-GFC regulations improving their capital adequacy, as well as the relatively short duration of this market downturn.
  • Consensus sees “Insurance” companies performing better than their counterparts within the broader sector, though we note that many major European banks actually have business operations covering multiple industries (and have been allocated just one industry here for simplicity of calculation), and therefore caution against looking too much into specific industry-level data. Overall, we think that the macro environment for Financials looks constructive, though earnings may be constrained by a high-base effect.

Table 5: Financials will likely do well, but earnings constrained by high-base effect

SectorIndustryEuro Stoxx 600 Weight (%)Consensus EPS Growth (YoY, %)
202120222023
FinancialsBanks7.5%135.2%-4.4%10.5%
Insurance4.9%39.3%7.8%7.2%
Financial Svcs3.9%32.5%-13.1%8.9%
Source: Bloomberg Finance L.P., iFAST compilations, iFAST estimates.
Data as of 27 Dec 2021.

Healthcare and IT – growth sectors set to perform well

We think that Growth sectors can also benefit from this improving macro backdrop. While we believe cyclicals, including the IT sector, should lead the recovery, we see strength in non-cyclical sectors as well like Healthcare. In general, the Healthcare sector contains pharmaceuticals, while the IT sector comprises high-tech manufacturing companies, with a mix of manufacturing and software companies.

  • The Healthcare sector will likely continue to perform well due to the ongoing pandemic, especially as the index includes companies like Astrazeneca, which may see more demand if COVID-19 boosters become the norm globally. Even without the ongoing global pandemic, demand for healthcare is likely to keep increasing in Europe and the developed world as consumers have higher incomes to afford better healthcare, and as Europe faces an ageing population.
  • The IT manufacturing sector can benefit from the ongoing chips shortage, with companies like ASML Holding NV (semiconductors MNC, specifically for computer chips) occupying a notable portion of the index. With the ongoing chips shortage, and the global recovery set to spur more chips demand, we think that this company can continue to post strong double-digit earnings growth in 2022.
  • There should also be greater demand for IT software, particularly with the ongoing economic climate which has two features: (i) the global recovery requiring more demand for business software, and; (ii) hybrid work arrangements necessitating more online and cloud solutions. Companies like SAP, which specialize in business software and cloud systems can benefit from heightened demand. 

Table 6: IT and Healthcare sectors see solid earnings growth in 2022

SectorEuro Stoxx 600 Weight (%)Consensus EPS Growth (YoY, %)
202120222023
Healthcare15.3%12.7%9.4%10.7%
IT7.6%40.9%14.6%16.0%
Source: Bloomberg Finance L.P., iFAST compilations, iFAST estimates.
Data as of 27 Dec 2021.

Overall Valuations are Appealing

Using P/E ratio as our valuation benchmark, we also find that valuations look appealing compared to other DMs (especially the US). The Euro Stoxx 600 has a z-score of about +0.5, which is slightly above average, but not as steep as the S&P500.

Table 7: Euro Stoxx 600 has a relatively attractive P/E ratio compared to peers…

P/E RatiosS&P 500Euro Stoxx 600Nikkei 225
Current P/E Ratio22.916.517.3
Average17.815.317.8
St. Dev.3.22.52.5
Z-score1.60.5-0.2
Source: Bloomberg Finance L.P., iFAST estimates. Data as of 27 Dec 2021.

We also find that when comparing with its (10-year) history, valuations do not look very elevated. In fact, valuations have actually been dropping steadily since the COVID-19 crash in Mar 2020, mainly due to improving earnings forecasts over the year.

Chart 6: … and compared to its past history (10 years)

Summary: EU equities still a relatively attractive play

In summary, we think that the growth and monetary policy outlook for Europe remain bright, and the top sectors of the Euro Stoxx 600 are well-placed for the global economic recovery due to their cyclical nature. Applying our designated fair P/E ratio of 16.5X for the index, we project a target price of 554 for the Euro Stoxx 600 by end-2023. This implies an upside potential of 14% over the next 2 years which we view as relatively attractive. Therefore, we maintain our 3.0 Stars “Attractive” rating on European equities.

Chart 7: Euro Stoxx 600 Price Performance and EPS

Table 8: European Equity Market Projections 2021 – 2023

Europe (Stoxx 600 Index)FY20FY21FY22FY23
PE Ratio (X)23.516.615.414.4
Expected Earnings Growth YoY-34%73%8%7%
Earnings Per Share (EPS)17.029.331.533.6
Projected Fair Price(based on fair P/E Ratio of 16.5X)554
Potential Upside from Today (%)14%
Source: Bloomberg Finance L.P., iFAST estimates. Data as of 27 Dec 2021.
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