Resilience amid uncertainty. Europe equities have shown resilience in 1Q24, in line with the global improvement in risk appetite, diminishing concerns about inflation, and the increased momentum of the AI-driven tech sector. Leading the gains were European semiconductor, luxury, and healthcare stocks, buoyed by robust earnings performances. Despite this, macroeconomic indicators have weakened, with the region narrowly avoiding a recession in 4Q23.

Market sentiment has been influenced by hopes of economic stabilisation and signs of nascent recovery, compounded by the ECB’s potential easing measures. Equity risk premium continues to be compressed, with the spread between earnings yield and bond yields nearing historic lows. Unless there is a significant decline in bond yields or a substantial improvement in earnings, the sustainability of gains in Europe equities appears uncertain.

During the 4Q reporting season, absolute earnings declined by 12.2% y/y but overall results surpassed consensus earnings estimates by 3.9%. However, there is considerable variation among sectors. Technology and financials exhibited positive earnings growth and surpassed expectations, whereas communications and consumer staples experienced both negative growth and surprise. More companies witnessed downgrades rather than upgrades to their earnings forecasts, reflecting a lack of confidence for a sustained recovery. Consensus estimates 3% earnings growth in 2024, dragged down by the IT and energy sectors, which we believe could have upside surprise judging by the orderbook and stable oil price.

Economy stabilising at weak levels. The economy is showing signs of stabilising at weakened levels, with certain indicators suggesting that conditions are, at the very least, not deteriorating further. Key indicators include PMIs that are beginning to rise but remain below the threshold of 50, an uptick in credit demand, stable bank lending conditions, and energy prices holding steady at around USD80/bbl.

Varying recovery within Eurozone. However, member countries are experiencing varying degrees of recovery. Among the core-4, Spain expanded by 0.6% q/q, followed by a 0.2% increase in Italy. This divergence is propelled by tailwinds such as a robust rebound in tourism, increased labour demand boosting participation rates, growth in the manufacturing/export sectors, and supportive fiscal policies. In contrast, Germany’s output contracted, narrowly avoiding a recession, while France experienced stagnation. Germany’s economic performance has been hampered by a slowing manufacturing sector, geopolitical challenges, high input costs, and slower growth in China over the past five to six quarters.

Europe’s geopolitical challenges

Geopolitical challenges are eroding investor confidence in European markets, impacting various facets of Europe’s economic performance, including trade disruptions, energy security, and regional integration. These uncertainties and risks pose threats to growth and stability, as discussed below.

Trade: Trade relations in Europe are vulnerable to geopolitical tensions such as trade disputes or sanctions, leading to reduced exports and increased costs for European businesses, thus affecting economic growth. In recent years, affected exports to US with Chinese parts, such as autos, apparel makers, and solar-energy manufacturers risk being held up in or sent back from US ports. As the US elections approach, the possibility of a second Trump term introduces the potential for new tariffs targeting the EU. Reports indicate that Trump may impose a blanket 10% tariff and countermeasures against European digital services taxes aimed at US Technology companies. ECB President Lagarde has warned that a Trump re-election could pose a significant threat to the EU’s interests, particularly in trade policies and climate change efforts.

Energy: Europe’s heavy reliance on energy imports, especially natural gas and oil, exposes it to geopolitical tensions in supplier regions like the Middle East or Russia, leading to supply disruptions and price spikes. However, Europe is actively addressing energy security concerns through diversification of sources and investments in renewable energy and efficiency.

Regional Integration: Geopolitical tensions within Europe, including disagreements between member states or separatist movements, can impede regional integration efforts, hindering the implementation of cohesive policies to address common economic challenges. Initiatives like the European Commission’s proposal for cross-border mergers in the telco sector aim to foster regional cohesion but may pose challenges for domestic companies. While we are less positive on the European market because of macro-economic weakness, certain sectors like luxury, tech, and healthcare present appealing opportunities. These industries boast global exposure, with earnings derived from international markets, and are positioned to benefit from long-term secular trends.

Sectors to watch

Luxury – bracing for recalibration. Shifting economic and political landscapes present nuanced challenges for the luxury sector, particularly affecting mid-tier buyers who have historically contributed significantly to luxury sales. We favour names that are aligned with the ‘Quiet Luxury’ theme, comprising brands that leverage shifting consumer mindsets to maintain superior profitability, as previously discussed in CIO Vantage Point: Luxury, Redefined. With subtle displays of affluence continuing to gain popularity amid growing social divide, these brands appeal to the ultra-wealthy who are well-buffered against sticky inflation and an era of elevated bond yields. Among luxury goods sales, jewellery has lagged leather goods to some degree until recently. Signs of change, as illustrated in the latest reporting season among luxury stocks such as Richemont (CFR SW) and LVMH (MC FP), indicate robust performance across various jewellery brands. This shift can be attributed to strategic efforts focused on product diversification, innovation, and a heightened focus on gold products and fine jewellery featuring contemporary and easily recognisable designs. Concurrently, there has been a concerted effort to enhance offerings at entry and mid-price points. These initiatives are anticipated to foster a more inclusive perception of jewellery, aligning it better with contemporary lifestyles where jewellery is seen as an everyday accessory. Traditionally associated with high price points and a focus on diamonds and intricate designs, jewellery has often been perceived as less suitable for daily wear, especially in professional settings. However, with the evolving product mix and emphasis on accessibility, there’s a growing recognition of jewellery as a versatile and wearable choice for various occasions, including the workplace.

Healthcare – Gaining with GLP-1. There’s considerable upside potential in the pharmaceutical realm. GLP-1 drugs, which target the protein glucagon-like peptide-1 (GLP-1) within the human body, garnered attention in 2021 when a specific GLP-1 medication demonstrated a remarkable ability to reduce body weight by 15% over 68 weeks. Initially designed to aid type-2 diabetes patients in managing blood glucose levels, these drugs gained widespread recognition, earning the moniker of a “blockbuster diet drug” across both mainstream and social media

However, the significance of GLP-1 drugs transcends weight loss alone. A pivotal moment for this drug class emerged in Aug 2023 when clinical data revealed their potential to decrease the occurrence of heart attacks, strokes, or fatalities from heart disease by 20%. Additionally, positive developments in clinical trials in Oct 2023 hinted at the possibility of utilising GLP-1 drugs in treating chronic kidney disease. These advancements forecast a potential 27% expansion in global user base to 1.2b by 2024, as per current 2024 statistics. Pharmaceutical companies worldwide are actively involved in R&D endeavours, vying for dominance in the relatively untapped GLP-1 market. We anticipate that FDA approvals and favourable clinical trial outcomes could significantly bolster the share prices of companies focusing on GLP-1 drugs. These include anticipated FDA approvals for GLP-1 drugs in treating cardiovascular disease and positive clinical data releases for its use in chronic kidney disease treatment, both anticipated in 2024.

For European pharmaceutical firms that successfully develop and market GLP-1 drugs, there lies a significant opportunity. By doing so, they can fortify their position in the diabetes treatment sector, fostering increased market share, brand recognition, and trust among healthcare professionals and patients. This strategic move can fuel revenue growth through the introduction of innovative therapies and the expansion of market reach.

Tech - All eyes on EUV. One of the prized industries within the Europe Tech sector is the EUV (Extreme Ultraviolet) sector. Key for semiconductor industries due to its advanced technology for lithography, this remains a critical process in semiconductor manufacturing. EUV lithography enables the creation of smaller and more complex semiconductor components, which is essential for meeting the demands of modern technology such as AI. With EUV technology, semiconductor manufacturers can produce chips with higher transistor densities, improved performance, and reduced power consumption. This technology is pivotal for enabling the development of next-generation electronic devices, including advanced processors, memory chips, and other integrated circuits. Consequently, the success and advancement of the EUV sector will directly impact the competitiveness and innovation capabilities of semiconductor industries worldwide.

We anticipate that the sector will sustain robust earnings growth despite US sanctions affecting Europe’s key customers. They have implemented a variety of strategic measures to circumvent these sanctions, drawing upon their global presence, diversifying partnerships, ensuring compliance, and engaging stakeholders to safeguard their interests. European tech firms are also proactive in engaging with European governments and regulatory bodies to advocate for policies that bolster their business interests and shield them from the extraterritorial impacts of US sanctions. This often involves diplomatic efforts to address concerns related to trade and investment restrictions imposed by the US. Additionally, the companies prioritise the development and sale of technologies not subject to US sanctions, thereby averting potential conflicts with US regulations. By investing in R&D and innovation, they can innovate their products and services, potentially diminishing their dependence on technologies subject to US sanctions. This strategic approach enhances their competitiveness and resilience when confronting regulatory challenges.

Banks – Mixed fortunes. 60-70% of European stocks have reported 4Q earnings, with earnings being weak, EPS beats nearing all-time lows, and an average y/y decline of 11% in bank earnings. As rates stay elevated going into 2024, challenges include higher funding costs and sluggish loan growth, amid continued weakness in most European economies. Outlook thus remains cautious from a NIM standpoint. Cost provisions remain mixed with this quarter seeing provisions from litigation and commercial real estate exposure. We expect growing pressure on deposit margins and asset quality.