Could the shift to value propel European equities in 2021?

John Bennett, Director of European Equities, shares his view on the outlook for European equities in 2021.

Key takeaways:

• In recent weeks, markets have shifted from growth to value, thanks in part to the monetary and fiscal response to the coronavirus pandemic.
• A lasting upward change in inflation expectations may be needed to cement a more enduring move into value.
• This could offer a great opportunity for European equities as an asset class, which represents more of a value construct relative to US equities.

I believe the biggest opportunity in 2021, in a sense, is for European Equities as an asset class. As a European Equities portfolio manager, my job is to operate within Europe and to pick stocks to the best of my ability within the region. However, before we even get to the stock picking stage, it is important to note that there is a great opportunity for the asset class itself in 2021. And what is that opportunity? It is the is the potential prospect for the asset class to outperform.

How might Europe’s value stance benefit the asset class in 2021?

This has been a very unlikely prospect for some time, given that Europe represents more of a value construct and it has been growth constructs – particularly the US, such as the Nasdaq, S&P 500 and the Dow Jones – that have performed so strongly over the last decade. However, I believe that the monetary, fiscal and geopolitical response to the coronavirus pandemic will be a gamechanger to this narrative. We have already seen the tides begin to turn in markets as value makes its way back to the fore after almost a decade and I do not see this stopping. In my opinion, the ingredients are lining up for European equities, and maybe also Japanese equities, to outperform. This is potentially a great opportunity for the asset class.

Weak inflation expectations would pose a threat

The biggest risk I see to this thesis is something that could derail any durable recovery of value stocks. The biggest danger, in my view, comes in the shape of a continuing deflationary, disinflationary narrative. For a value rally to prove enduring, we firmly believe that there needs to be an accompanying macro-economic change: a pick-up in inflation expectations. A continued deflationary environment would prove to be a headwind for value stocks and European equities would not have a great prospect of outperforming the leader for the last decade – US equities. The risk is that this turning point from growth to value fails to persist because inflation expectations do not pick up. However, I do not think this will be the case.

For me, the biggest question for 2021 is: will value durably outperform growth? The answer to this relies on inflation expectations picking up. So, I think the single biggest theme for European equities in 2021 will be inflation expectations and, by extension, the bond yield curve. It would not be in the interest of value stocks for German bund yields to sink lower and it is my belief that, given the macroeconomic backdrop, the yield curve may normalise and steepen slightly albeit not necessarily dramatically.

Evidence of an economic rebound

Coupled with this, I think we are likely to see a vigorous economic rebound after a long period of subdued economic activity owing to the measures put in place to prevent the spread of COVID-19. In fact, the industrial sphere has already shown signs of an economic rebound and, given the increase in consumer savings ratios that is happening just about everywhere, it is only a matter of time before this rebound is reflected in the consumer sphere too. Many people are itching to get out, to travel and to enjoy themselves and once this happens, we are likely to see an economic boom. If this turns out to be an inflationary boom, or even just a minor pick-up in inflation expectations, it will be a gamechanger in the type of stocks that investors want to own and, if I am correct in this, they will want to own value.

Glossary

Value stocks – a share of a company that trades at a lower price relative to its fundamental metrics and is therefore believed to be undervalued by the market.

Growth stocks – a share in a company that investors anticipate will grow at a rate significantly above the average growth for the market.

Monetary policy – policies made by central banks, to influence the level of inflation and growth in an economy. This includes controlling interest rates and the supply of money.

Fiscal policy – government policy relating to setting tax rates and spending levels.

Deflation/disinflation – deflation is a decrease in the price of goods and services across the economy, usually indicating that the economy is weakening. This is the opposite of inflation. Disinflation is a decrease in inflation rates.

Inflation expectations – expectations of the future path of inflation.

Yield curve – A graph that plots the yields of similar quality bonds against their maturities. In a normal/upward sloping yield curve, longer maturity bond yields are higher than short-term bond yields. A yield curve can signal market expectations about a country’s economic direction.

I believe the biggest opportunity in 2021, in a sense, is for European Equities as an asset class. As a European Equities portfolio manager, my job is to operate within Europe and to pick stocks to the best of my ability within the region. However, before we even get to the stock picking stage, it is important to note that there is a great opportunity for the asset class itself in 2021. And what is that opportunity? It is the is the potential prospect for the asset class to outperform.

How might Europe’s value stance benefit the asset class in 2021?

This has been a very unlikely prospect for some time, given that Europe represents more of a value construct and it has been growth constructs – particularly the US, such as the Nasdaq, S&P 500 and the Dow Jones – that have performed so strongly over the last decade. However, I believe that the monetary, fiscal and geopolitical response to the coronavirus pandemic will be a gamechanger to this narrative. We have already seen the tides begin to turn in markets as value makes its way back to the fore after almost a decade and I do not see this stopping. In my opinion, the ingredients are lining up for European equities, and maybe also Japanese equities, to outperform. This is potentially a great opportunity for the asset class.

Weak inflation expectations would pose a threat

The biggest risk I see to this thesis is something that could derail any durable recovery of value stocks. The biggest danger, in my view, comes in the shape of a continuing deflationary, disinflationary narrative. For a value rally to prove enduring, we firmly believe that there needs to be an accompanying macro-economic change: a pick-up in inflation expectations. A continued deflationary environment would prove to be a headwind for value stocks and European equities would not have a great prospect of outperforming the leader for the last decade – US equities. The risk is that this turning point from growth to value fails to persist because inflation expectations do not pick up. However, I do not think this will be the case.

For me, the biggest question for 2021 is: will value durably outperform growth? The answer to this relies on inflation expectations picking up. So, I think the single biggest theme for European equities in 2021 will be inflation expectations and, by extension, the bond yield curve. It would not be in the interest of value stocks for German bund yields to sink lower and it is my belief that, given the macroeconomic backdrop, the yield curve may normalise and steepen slightly albeit not necessarily dramatically.

Evidence of an economic rebound

Coupled with this, I think we are likely to see a vigorous economic rebound after a long period of subdued economic activity owing to the measures put in place to prevent the spread of COVID-19. In fact, the industrial sphere has already shown signs of an economic rebound and, given the increase in consumer savings ratios that is happening just about everywhere, it is only a matter of time before this rebound is reflected in the consumer sphere too. Many people are itching to get out, to travel and to enjoy themselves and once this happens, we are likely to see an economic boom. If this turns out to be an inflationary boom, or even just a minor pick-up in inflation expectations, it will be a gamechanger in the type of stocks that investors want to own and, if I am correct in this, they will want to own value.

Value stocks – a share of a company that trades at a lower price relative to its fundamental metrics and is therefore believed to be undervalued by the market.

Growth stocks – a share in a company that investors anticipate will grow at a rate significantly above the average growth for the market.

Monetary policy – policies made by central banks, to influence the level of inflation and growth in an economy. This includes controlling interest rates and the supply of money.

Fiscal policy – government policy relating to setting tax rates and spending levels.

Deflation/disinflation – deflation is a decrease in the price of goods and services across the economy, usually indicating that the economy is weakening. This is the opposite of inflation. Disinflation is a decrease in inflation rates.

Inflation expectations – expectations of the future path of inflation.

Yield curve – A graph that plots the yields of similar quality bonds against their maturities. In a normal/upward sloping yield curve, longer maturity bond yields are higher than short-term bond yields. A yield curve can signal market expectations about a country’s economic direction.