European equity valuations look attractive after a mixed third quarter earnings season but the dispersion between companies is growing, “creating opportunities for stock pickers”, according to Helen Jewell, chief investment officer of BlackRock fundamental equities.
Deglobalisation and decarbonisation are two mega trends that will drive growth for industrial companies especially, but which will amplify the spread between stocks and sectors.
“We believe the current business cycle is playing out in a manner that differs from the past, creating dispersion within markets and opportunities for stock pickers to achieve above-market returns,” she explained.
Cyclical companies, whose earnings should be closely correlated to economic growth, are not behaving cyclically, she said.
Usually, when the economy slows, there is less demand for products so inventories build up. Companies offer discounts to clear their stockpiles, which hits their earnings. That process is not happening currently in some industries, such as semiconductors and the aerospace supply chain, because supply is unable to keep pace with demand.
Consumer spending has proved resilient despite higher inflation and interest rates. Savings in Europe and the UK remain above pre-pandemic levels, energy prices have come down from their highs last year, and the impact of higher rates is not being felt universally.
Against this backdrop, BlackRock’s fundamental equities team is looking for companies that will be able to withstand a consumer slowdown, once people’s savings run dry.
“We see opportunities across e-commerce, travel and luxury companies, but we focus on quality characteristics such as a strong brand and healthy cash levels,” Jewell said.
Industrial companies may be cyclical in nature, but decarbonisation and deglobalisation are creating new growth opportunities, as evidenced during the third quarter earnings season. Companies reported increased sales due to “investment in power grids necessary for the energy transition, electrical infrastructure for data centres, the reshoring of manufacturing, the need for battery plants and the production of air compressors required for the hydrogen industry and carbon capture,” Jewell said.
As a result, European industrials have higher earnings growth estimates for next year than any other sector except for materials.
The fundamental equities team is investing in industrial companies that have a leading market share, have prioritised research and development, and can maximise opportunities created by electrification and automation. European industrials maybe cheaper than similar companies in the US but they can still benefit from US government spending on the energy transition and on supply chain security, Jewell observed.
Looking at European equities more broadly, third quarter earnings fell by an average of 14% compared to a year ago, which was in line with expectations. However, companies whose third quarter earnings missed analysts’ expectations – even slightly – were excessively punished by markets.
The companies whose share prices fell furthest after earnings misses were those with the most stable earnings over the past five years. As a result, many quality companies are now available at attractive valuations.
“Some of these companies have suffered earnings disruptions that warrant lower valuations. Yet many are seeing revenue return to more normal levels after a few years of stellar sales. We believe the market has overcorrected in these cases, reflecting an uncertain macroeconomic environment and growing fears of recession,” Jewell explained.
BlackRock’s medium-term outlook for European equities is “bright”, Jewell said, given that valuations look attractive and could recover swiftly if the economic outlook improves. However, she warned that “selectivity will remain key as the cycle evolves and companies adjust to a new regime of higher rates.”