There’s never a dull moment in markets and the past few weeks in Europe have been testament to that. We asked David Lambert, head of our European Equity team, to share the team’s views on the year ahead.

Obviously, the first question must be – what are your thoughts on recent events in the European banking sector?

Everything is subject to change at present and the situation is very fluid, so visibility isn't ideal, however we believe what we've seen recently is not systemic, and the issues surrounding Silicon Valley Bank and Credit Suisse are idiosyncratic. Credit Suisse had undergone many years of management issues and restructuring, and in our view, what’s happened is a near-term positive in providing a resolution.

Overall, European regulation remains stringent, however, on the more cautious side, we believe that we'll see increased regulatory scrutiny across the sector, as well as increases in funding costs. This rise in cost of capital will make it more difficult to earn excess returns.

Investor confidence will likely remain fragile over the short term, and although we see recent events as company-specific, broader fears of stress in certain pockets of the sector will continue to play out.

That’s an interesting point on cost of capital. Could you expand on that, and share some further insights?

In the companies we own, we favour higher return on capital (ROC) over cost of capital, and we like to see returns that are consistent and persistent, coupled with asset growth. These are the fundamental ingredients for compound and shareholder equity in the medium to long term. That dynamic is always tricky to find in European banks, and recent events won't help. Over the past 18 months, two of the drivers of banks’ performance have been rising rates and capital returns (in terms of large dividends coupled with buybacks), and these drivers have also faded.

Another potential outcome is that the regulatory burdens on some European banks may prove to be appropriate and to protect most of the system. If that is the case, certain European banks may emerge looking very attractive.

Looking at the broader equity market, clearly the equity risk premium has increased, but reduced rising rate expectations will help longer-duration assets, and in the equity market that typically means quality and growth franchises.

What gives you cause for optimism currently, as European equity investors?

As bottom-up stock pickers, we continue to focus on the micro – the company specifics – and we’re constructive in many areas where we see good earnings momentum and attractive valuations. The fact that Europe is trading at around 11.5x earnings,¹ with next year’s earnings still well below the long-term average, and much cheaper than the United States, means we’re seeing valuation support coupled with earnings revision.

Over the past six to nine months, we've witnessed consistent outperformance, particularly relative to the United States, and we believe that this has been a function of cheap valuations, both absolute and relative, coupled with extraordinary earnings.

Europe has been cheap before but never at this level and for so long. Valuation-wise, what are your views on the Eurozone versus the United States?

Europe is undoubtedly a lower return region and should therefore trade at a price/earnings (P/E) discount, but current valuations show – using normalized sector exposure between the two regions – a substantial discount to the United States. In our view, this has been the main support for Europe more recently, particularly as we've moved back into a higher rate environment. With higher rates, the present value of future cashflows becomes squeezed. Europe is much less susceptible to this dynamic.

European earnings have lagged those of the United States since the global financial crisis of 2008, however we recently saw new, absolute highs and we believe that the gap will continue to narrow.

European consensus forecasts are weakening, after remaining stubbornly strong for most of 2022. Can you give some context around that?

Europe, and the U.K. in particular, saw double-digit earnings growth over the first nine months of 2022,² while the United States witnessed a steady decline after the first quarter. Thus, there was a meaningful divergence in the earnings performance of the two regions last year. We’ve seen a slight softening in expectations over the last three months, but in the most recent quarter’s results, the annualized rate of earnings growth was still positive, albeit marginally so.

Therefore, we suspect that consensus expectations are still too low. The real earnings growth forecast by the market is the most pessimistic it's been for 25 years, and last year it was also the most pessimistic it had been for the previous 25 years. And this pessimism, so far, is not coming to pass.

As a team, which indicators are you looking at to help understand the direction of travel?

We look at Purchasing Managers Indices (PMIs), as these tend to be strong indicators for earnings growth, which in turn drives markets. PMIs remain robust, and this is providing some macro support to the region. Much of this is attributable to the fall in gas prices and the reopening in China. However, we need to remain alert to things like the inventory cycle, which has been a tailwind for many corporates, and we observe PMIs carefully for signals.

Additionally, we can’t not mention inflation. We believe that there will be some rapidity in the descent, starting in the coming months. Notwithstanding recent events in the banking sector, this would imply that we’re closer to an end of the tightening cycle, and from a style perspective, this could prove supportive to the de-rated quality area of the market. We see some excellent investment opportunities here and much cheaper valuations than we’ve seen for some time.

We also look at risk from central banks. Interest rates remaining higher for longer would impact consumers negatively, yet unemployment remains stubbornly low. If that began to unwind aggressively, there could be a more severe pullback in earnings, but for now we believe that is limited.

There are lots of moving parts at the moment. How do you focus on what matters, as fundamental stock pickers?

There’s a lot of macro noise, but our priority is to concentrate on looking at businesses with high, sustainable, consistent, long-term returns that have low capital intensity. These businesses tend to have a degree of moat around them, and a degree of strength which allows them to capitalize on macro downturns.

Focusing on high return, positive spread businesses that continually reinvest in themselves remains key in compounding returns for shareholders over the long term. Many businesses across Europe have become a lot cheaper in the past 18 months, and we believe that this sets us up for some great, long-term entry points into some attractive franchises.