Can Europe rival the US?

Where the fund is positioned and earnings

Investors who have favoured the US over Europe in the past decade will probably be happy with their choice. In aggregate, US stock markets have outpaced their European peers since the Global Financial Crisis. However, history suggests that this is temporary rather than structural. Today, there are sound reasons to believe that carefully selected European companies may attract more investor attention from here.  

Investors have persistently misjudged Europe. With some justification, they have argued that its combination of weak demographics, poor productivity and high government debt make it a more difficult place for companies to thrive. But European companies aren’t proxies for European economies. More than half of revenues generated by European companies come from outside Europe.

The prevailing scepticism about European economies has seen significant asset flows out of European markets. European-domiciled long-term funds saw net outflows of €130bn in 2022, their worst year since 2008[1], capping a difficult decade. At the same time, there remain concerns about corporate earnings for European companies. Can they meet current estimates?  

These are valid concerns, but there are signs that this gloom is starting to lift with fund flows tentatively returning and performance picking up. As stockpickers rather than economists, we claim no insight into the spark that has ignited it. It may be because investors are growing disillusioned with the US, and Europe appears to be the next best option. Or it may be because they have spotted that valuations for MSCI Europe are notably lower than for the broader MSCI World index, while dividend yields are higher.[2] Either way, it only needs a relatively small shift in fund flows to galvanise the market.

Uncertain earnings

That said, European markets still merit selectivity. The earnings outlook is uncertain and on the Fidelity European Trust, we see some potential weak spots, where expectations remain too high. In an environment of higher input costs, where sales volumes are relatively fixed (at least in the short term), pricing power needs to do a lot of the heavy lifting on earnings growth – and this will create winners and losers.    

In this environment, we believe sectors such as industrials, telecoms or utilities will struggle. The telecoms companies will find it difficult to impose price rises on hard-pressed and low income consumers. Utilities have regulated cost and revenue bases. They may be able to hide a little behind power increases, but it is also not easy for them to push price rises through. Real estate also faces a tough environment as interest rates rise.

In contrast, we see significant opportunities in aerospace and defence, luxury goods and software, where earnings expectations are realistic and there are prospects of strong growth even in a weakening economic climate. Aerospace engines, for example, make for attractive investments in a recession because the industry has high barriers to entry and high-margin aftermarket revenues. It took a hit during the pandemic, but companies such as portfolio holding MTU Aero Engines look resilient. MTU has considerable structural drivers, with exposure to global passenger traffic growth, global e-commerce, and the fast-growing German defence budget.

Earnings estimates for the software sub-sector have already tumbled. There are also still pockets within the industry that are operating below pre-COVID levels. A good example of this is portfolio holding Amadeus, the Spanish booking platform and IT solutions provider for the travel and hotel industries, whose passenger boarded volumes (the metric it uses to bill clients) are only expected to fully recover by the end of 2023. It has reduced its costs and we expect the legacy of the pandemic will increase the willingness of airlines to outsource. A number of competitors have left the market. This is all positive for future earnings.

Reviving markets

For luxury goods, there are still companies trading below pre-Covid levels with the scope to recover. 2023 should see Chinese tourists return. Given the Chinese consumer’s propensity to buy luxury goods abroad, the European luxury sector could receive a boost. We hold LVMH and Hermes International in the portfolio, both strong brands with a well-established history.

These are all well-priced with, we believe, a strong pipeline of earnings growth. They also have lower valuations. If these lower valuations aren’t recognised by equity investors, trade or private equity buyers may emerge. However, we are confident that at some point the inherent value in these companies will be realised.

In the meantime, we continue to focus our attention on finding those companies that grow their dividends above inflation. These companies are rare. Only 46 companies in our reference index have consistently grown their dividend over the last five years, while 273 companies have either cut or held their dividends at some point. We believe fishing in that pool gives us the greatest chance of success.

European stock markets hold promise for the year ahead, but the economic environment will pose challenges for certain segments. Careful stockpicking in areas where valuations are not ambitious, and earnings may be turning a corner is key to unlocking value.
 

Important information

The value of investments and the income from them can go down as well as up, so you may get back less than you invest. Past performance is not a reliable indicator of future returns. Investors should note that the views expressed may no longer be current and may have already been acted upon. Overseas investments are subject to currency fluctuations. Fidelity European Trust PLC can use financial derivative instruments for investment purposes, which may expose it to a higher degree of risk and can cause investments to experience larger than average price fluctuations. The shares in the investment trust are listed on the London Stock Exchange and their price is affected by supply and demand. The investment trust can gain additional exposure to the market, known as gearing, potentially increasing volatility. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to an authorised financial adviser. Reference to specific securities should not be construed as a recommendation to buy or sell these securities and is included for the purposes of illustration only.

The latest annual reports, key information document (KID) and factsheets can be obtained from our website at www.fidelity.co.uk/its or by calling 0800 41 41 10. The full prospectus may also be obtained from Fidelity. The Alternative Investment Fund Manager (AIFM) of Fidelity Investment Trusts is FIL Investment Services (UK) Limited. Issued by Financial Administration Services Limited, authorised and regulated by the Financial Conduct Authority. Fidelity, Fidelity International, the Fidelity International logo and F symbol are trademarks of FIL Limited. UKM0323/381377/ISSCO00116/NA