Investing in a European revival

The shift has been abrupt. Until just a few months ago, money continued to pour into US markets, as investors continued to chase the US AI trade. However, the maelstrom of trade policy created by the new administration has seen a sudden shift in capital allocation out of the US and towards Europe. Year to date, European equities have seen $15.8bn in passive inflows alone¹. 

The relative size of European and US markets – the market capitalisation of the whole French market is only marginally larger than that of Apple^2,3 - means that it doesn’t take a significant shift in allocation towards Europe to produce a meaningful move in the European equity markets. Since the start of the year, the Euro Stoxx 50⁴ has outpaced the S&P 500⁵ by around 13%.

Sentiment has also seen a significant shift. Bank of America’s latest European Fund Manager Survey records a net 39% of survey participants saying they are overweight European equities relative to global markets, up from 12% in February and the biggest overweight since mid-20216. 

There are tangible reasons why investors are targeting Europe. After a long period out of the spotlight, valuations for European equities look attractive relative to US equities. While the gap has closed slightly, Europe still trades on an average valuation discount to the US of over 40% and there is still some way to go before we return to historic median levels.

There is also a sense that Europe may ultimately benefit from being forced to reduce its historic dependency on the US. The first sign has been Germany’s unprecedented fiscal stimulus package, which upends its long-running debt brake and unleashes a wave of infrastructure and defence spending.

It is difficult to underestimate the importance of Germany’s move – both as a symbolic shift and in purely financial terms. The €500bn for infrastructure investment equates to 11.6% of Germany’s 2024 GDP, to be spent in the coming 10 years⁷. The proposed constitutional reform to exclude defence spending of more than 1% of GDP from the debt brake will enable an open-ended rise in expenditure, which should also stimulate the broader economy.

Germany’s actions sit alongside action from the European Union. The European Council recently approved a proposal to exempt defence spending from the EU’s fiscal rules and to set up a €150bn EU loan facility to fund military expenditure. These actions from Germany and the EU should be a meaningful boost to regional economic growth over the next five years.

However, there are still headwinds. The tariff regime emerging from the White House is unpredictable and may yet inflict damage on European companies. Equally, the immediate beneficiaries of the spending - the defence companies – have already seen their share prices move significantly higher, to a level that may over-estimate their value.

Investors cannot afford to be indiscriminate in their approach to European markets. In the Fidelity European Trust, our optimism about the outlook for European equities is balanced with pragmatism about the still-difficult environment in the region. We continue to favour high quality companies that have exhibited long-term dividend growth.

These are companies such as Ryanair, which is a low-cost provider in a competitive and commoditised industry. It has the best management team in its sector. It owns rather than leases its planes and has one of the highest route densities in Europe. Its attractive valuation provides a significant cushion, and its top line should revive in a more normal environment for air travel.

The trust also holds TotalEnergies. Energy companies are usually cyclical, but Total has still managed to pay a consistent dividend every year to shareholders. It is a sign of a capable management team, with strong forward planning. TotalEnergies has also refocused on more renewable energy sources.

Equally, the US is not the only game in town on AI. In reality, the potential beneficiaries of AI can be found around the world. Legrand, for example, is a less obvious beneficiary of the AI boom. It makes ‘white space’ equipment for data centres, such as power distribution units, switches, transformers. It also has a well-positioned residential and non-residential construction business. It trades at a fraction of the valuation levels of AI giants in the US.

This is unquestionably a time to be more enthusiastic about Europe, but there are also reasons for caution. Our approach is to continue to focus on attractively valued companies with strong balance sheets that should be resilient, and able to grow dividends even in a more uncertain environment. We believe this is a prudent way to invest in the European revival.