Spotlight on Europe: Renaissance or Reckoning?

European equity market returns have lagged those of the U.S. for much of the past decade. This year, the region has been a surprise performer with the German equity market (Dax Index) and French equity market (CAC 40 Index) touching new all-time highs in April and May and continuing to outperform most markets globally on a one-year basis. While markets have moved and the U.S. has seen relatively strong performance year-to-date, the question remains: Should investors expect Europe’s strong performance to continue?

European equity markets have shown unexpected strength over the past 12 months with their gains outpacing those of many other international markets. The eurozone region fared much better than feared given the potential energy crisis sparked by the Russia-Ukraine conflict. The combination of swift actions last fall to refill energy storage, a milder winter, sensible fiscal and monetary policy, and wholesale energy prices largely returning to levels before Russia’s invasion of Ukraine allowed the region to avoid the steep economic downturn that many economists had forecasted. Apart from specific problems with Credit Suisse, the region’s banking sector has also avoided any contagion from the troubles of its U.S. counterparts. Investor attention has been increasingly turning to the region given its stronger than expected resilience and growing visibility surrounding geopolitical risks.

Background

Russia’s invasion of Ukraine triggered large downward revisions to European economic forecasts last year as energy supply from Russia into the eurozone was drastically reduced. The unprecedented blockage of gas flow to Europe ignited one of the largest global energy shocks since the 1970s. Despite the conflict continuing for longer than expected, the European economy proved to be more resilient than many expected. Swift action by European governments meant that an influx of imported gas helped keep the lights on and factories producing over the winter months. Despite the war, policymakers continued to battle inflation and increased the key interest rate from 0.0% to 4.25% over the past year. Recent upgrades to both consumption and wage growth estimates are consistent with a stronger than forecasted economy.

The Energy Crisis

Last summer, there were forecasts of mandated energy rationing and industrial shutdowns over the winter, neither of which materialized, thanks in large part to some luck with the second warmest winter on record along with quickly arranged deliveries of liquified natural gas (LNG). The situation would have been much worse had China’s zero-COVID policy not reduced demand for LNG in China. As things stand today, gas storage levels are well above historical averages, meaning a scramble for energy heading into this year’s winter is unlikely (Exhibit 1). The wholesale price for Europe-wide natural gas, as measured by the benchmark Dutch T.T.F. futures contract, is down 85% from the peak last August and has returned to levels last seen before the Ukrainian invasion.

Today, there is much more visibility heading into this year’s winter. Europe has added 40 billion cubic meters of gas into its storage facilities over the past five months and has reached its target of filling gas storage facilities to 90% of capacity more than two months ahead of the November 1 deadline. For context, 70 billion cubic meters were added in the scramble of 2022, which explains why prices surged to all-time highs last year.

Interest Rates: The Peak in Sight?

While the president of the European Central Bank (ECB) has not been as outspoken as the Federal Reserve (Fed) chairman with regard to signaling a potential peak in the rate hiking cycle, we can take comfort that the peak of eurozone interest rates is likely within sight. Bessemer’s view is that it is unlikely that the ECB will raise rates much further, especially if the Fed is indeed at its rate cycle peak, in an effort to avoid making a policy error by over tightening.

The ECB has a singular policy mandate — to control inflation — whereas the Fed has a dual mandate of price stability, as measured by a 2% personal consumption expenditure (PCE) inflation rate and a goal of “maximum sustainable employment,” most recently estimated to be a 4.1% unemployment rate. The ECB has been steadfast and vocal in reminding markets that it has a specific singular mandate. There remains a risk that the central bank continues to overtighten with the aim of hitting its inflation goal at the expense of economic growth. If this were to happen, it is likely that the euro currency could also strengthen, offsetting some of the potential equity market losses for U.S. dollar-based investors.

Economic Growth: Possibility of a Soft Landing

Rate hikes on both sides of the Atlantic are having the intended effect of slowing economic growth. The eurozone technically entered a recession (defined as two consecutive quarters of declining real GDP) in the first quarter of 2023 but has returned to 0.3% growth in the second quarter. The U.S. also witnessed its growth slow but has so far avoided any overall economic contraction. Both regions are expected to post slow, albeit positive, growth in the coming quarters. For calendar year 2023, expectations are for 2.0% real GDP YoY% for the U.S. and 0.6% for the eurozone, followed by 0.8% and 1.0%, respectively, in 2024.

2023 Earnings: Better Than Expectations

European first and second quarter earnings have been stronger than expectations despite some slightly disappointing sales numbers. A higher-than-average number of companies across a broad range of sectors beat expectations in the first half of the year. China’s reopening painted a mixed picture of European company earnings with evidence of varying degrees of recovery of company operations in the region. Consumer and luxury goods companies (e.g., LVMH, Kering, and Hermes) saw a sharp reacceleration in their Asia sales growth. In contrast, the spirits company Pernod Ricard and brewer Heineken missed expectations on weaker-than-expected alcohol volume growth. There was no evidence that the contagion from the problems in the U.S. banking sector had spilled over to Europe as overall European bank results were reassuring with the EuroStoxx Banks Index up 15% on the year, in sharp contrast to the S&P 500 banks index’s decline of 9% on the year.

The Eurozone Banking Sector Is Resilient

There was a feeling of schadenfreude from some areas of European banking as problems in the U.S. banking sector unfolded earlier in the year. With the most acute period of banking stress seemingly having passed, the EU banking sector looks set to emerge relatively unscathed. The primary reason for this is that the European banks are bound by a different regulatory structure than their U.S. counterparts. The stringent capital and liquidity requirements that have hampered European banks’ profitability over the past 10 years mean that the sector has been better able to withstand periods of banking stress (Exhibit 2). The Basel III regulatory framework that was designed in 2011 following the Global Financial Crisis requires banks in the region to hold considerably higher capitalization levels and wider liquidity buffers than banks in the U.S. In addition to stricter regulation, the more concentrated nature of European banking and a typically higher proportion of retail deposits to corporate deposits has led to the area experiencing fewer movements in deposit flows relative to its U.S. counterparts.

Europe as a Play on China

As U.S.-Sino geopolitical tensions remain high, investors are looking at alternative ways to access exposure to the long-term growth trends in China. Europe has relatively strong economic ties to China, and this is reflected at the revenue level as China accounts for a higher share of Europe’s revenues compared to other developing countries. Luxury goods are an area where European companies dominate as the region is home to LVMH Moet Hennessy, Hermes, Kering (Gucci, Bottega Veneta), and Richemont (Cartier and Van Cleef & Arpels). Some analysts expect luxury goods sales in China to increase by as much as 40% this year as spending continues to rebound from COVID-19 lockdowns. LVMH (a Bessemer holding) is set to be among the biggest beneficiaries of China’s return to normalization. LVMH shares are up 16% this year compared to the Chinese stock market (Shanghai Shenzen CSI 300), which is down 5%.

Given the Brighter Outlook for Europe, Should Investors Be Looking Beyond U.S. Markets for Outsized Returns?

Although European equities have outperformed the U.S. equity market over the past 12 months, they continue to lag well behind on a longer-term basis. At an index level, the European equity market (MSCI Europe ex UK) is only 30% higher than its March 2000 dot-com peak over 20 years ago. Over the same time period, the S&P 500 is 190% higher. In total return terms (dividends reinvested), the U.S. market has provided more than double the returns of the European market (370% versus 170%) since December 31, 1999 (Exhibit 3).

Should We Expect Eurozone Equities to “Catch Up” to U.S. Equities?

It is important to note that the two geographies have very different underlying market dynamics; they should not simply be compared at an index level. A key factor behind the large dispersion in returns over the past 20 years stems from valuation differences driven primarily by the differing weights of the technology and communication services sectors of each area.

Valuation: Buying Opportunity or Value Trap?

The price-to-earnings multiple expansion that has occurred in the U.S. market over the past 10 years is unique to the U.S. market. The so-called “Magnificent Seven” (Apple, Microsoft, Amazon, Alphabet, Nvidia, Tesla, Meta) stocks represented only 4.9% of the S&P 500 index in March 2009 but have grown to 27% of the index today. In Exhibit 4 below, we can see that the valuation premium of the U.S. market has coincided with the performance of these companies. The Magnificent Seven companies represent the so-called new economy and derive much of their value from the future forecasted profits that investors expect will accrue to these market-leading companies. Europe does not have any similar companies, and so investors should therefore not simply expect the European market to “catch up” or for the U.S. market multiple to fall back to long term historical levels. Bessemer believes that there has been a structural change in valuation between the two regions’ stock markets driven by index composition.

The composition of the eurozone equity market has hampered its growth prospects over the past decade. With relatively fewer technology companies and more cyclical material, industrial, and financial companies, European equities have been less profitable than those of the U.S. in this market environment. In Exhibit 5, we can see that the S&P 500 index has a significantly larger weighting to the technology and communications services sectors (36.6%) than Europe (13%). The technology and communications services sectors tend to be characterized by recurring and moat-protected profits, leading the U.S. market to generally trade at a higher valuation relative to European markets. In contrast, Europe is comprised of many more asset-heavy industrial companies (16.4% of the Europe index versus 8.5% for the U.S.) that are generally more cyclical and, in some cases, less profitable. Still, Bessemer portfolio managers have found select areas of opportunity in European companies with competitive advantages and attractive valuations through thoughtful bottom-up analysis.

Bessemer Positioning — European Public Markets

Europe is home to many world-leading “best-in-class” companies that are well positioned to benefit from global growth. Overall, Bessemer’s All Equity Model Portfolio is underweight European stocks relative to its benchmark as we are currently finding more compelling investment opportunities in the U.S., though we continue to seek investment opportunities in other geographies. Bessemer portfolios currently have exposure to the following European holdings, a reflection of their emphasis on owning both high-quality companies benefiting from secular tailwinds as well as selectively seeking exposure to cyclical industries with attractive relative valuations.

There is room for optimism for high-end consumers, who in many cases are benefiting from the rising interest rate environment given that cash balances have started earning interest for the first time in a decade. LVMH Moet Hennessy Louis Vuitton allows for Bessemer portfolios to maintain exposure to the higher-end consumer, and we believe that the company is well positioned for a continued catch-up on Chinese spending after the lifting of lockdown restrictions.

The Dutch company ASML is one of very few companies in the world that have the knowledge and expertise to make semiconductor chips out of silicon wafers. The company is a critical link in the global economic supply chain and has a near monopoly in the highly complex semiconductor equipment manufacturing sector.

Siemens AG of Germany is the largest industrial manufacturing company in Europe and makes everything from healthcare and building technologies to factory automation and power distribution equipment. Its Digital Industries segment makes up approximately 25% of sales and focuses on cloud based industrial internet of things (IoT) operating systems primarily in manufacturing.

Airbus is Europe’s leading defense, aircraft, and space enterprise. Bessemer believes defense companies will see a significant boost in sales given Europe’s commitment to increase defense spending as Russia’s invasion of Ukraine reinforces the proximity of real threats in the region. For example, Germany has stated it will double its defense budget to EU100 billion in the coming years.

Bessemer Positioning — European Private Market

Bessemer private market investments are focused on the underpenetrated family-owned business landscape and ongoing corporate spinout activity. The biotechnology and software sectors are underrepresented in the public markets in Europe, but our private equity managers find many opportunities on the private side in these sectors. Typically, the smaller private companies in Europe have much higher growth rates than the more mature public market companies.

Exhibit 6 shows that private equity funds in Europe have generated very similar returns to those in the U.S. over the past 20 years: 16.4% vs 15.4%, respectively. These returns sharply contrast with the much lower public equity market returns in both regions over the same time period. The MSCI North America index has returned an annualized 9.1% against a 5.0% annualized return for the MSCI Europe Index.

Conclusion

The last 10 years have seen the U.S. public equity market significantly outperform the European public equity market. The strong earnings growth of the U.S. technology and communication services sectors were primary drivers of this outperformance. While the valuation expansion that came with this earnings growth is unlikely to continue at the same rate, there are reasons to believe it can be maintained. In our view, the key to outperformance will be individual stock selection through active management identifying high-quality companies that are able to compound at above average growth rates, command pricing power, and gain exposure to developing trends. Bessemer portfolios are invested in and are constantly seeking these types of companies at attractive valuations.