Investors could be forgiven for avoiding European equities in recent years given lacklustre economic growth and political uncertainty but Heartwood Investment Management believes there are a number of positives for region. 
That said, the asset management house also thinks there are notable headwinds which mean investors should be reluctant to take hefty bets on the region if conditions continue to deteriorate.
Over the past five years, the Euro STOXX index’s 35.93 per cent total return (in local currency terms) has underperformed the FTSE All Share, MSCI Emerging Markets, MSCI World, S&P 500 and Topix. The S&P 500 made 69.34 per cent over this time.
Performance of indices over 2019 in local currencies
Source: FE Analytics
Over 2019 so far, however, European equities have rallied and – as the chart above shows – have outperformed most of their international peers with a total return of close to 15 per cent.
Nikki Howes, investment associate at Heartwood Investment Management, noted that there is a “mixed” economic picture for Europe with conditions in its manufacturing sector worsening over 2019 while the service sector has held up “relatively well”.
So how should investors approach European equities against this uncertain backdrop?
Howes pointed out that there are a number of reasons to be optimistic about the outlook for Europe, not least the fact that weakness in the euro is good news for its exporters.
The euro has been weakening against the dollar since mid-2018 and, as Europe exports more than it imports, the region’s exporters benefit from the value of their foreign earnings increasing in euro terms.
“In the past, euro weakness has tended to correlate with a rising stock market in Europe, but this rise typically lags currency weakness as it takes time to show up in reported company earnings,” she explained. “As a result, the euro weakness experienced last year should now be good news for the stock market in the near term.”
In addition, recent pledges from the European Central Bank to keep monetary policy supportive contributed to a further drift down in the euro, which should continue to benefit European stocks.
Performance of euro vs dollar over 1yr
Source: FE Analytics
The second reason to be positive on European equities, according to Howes, is the fading impact of several one-off issues that now appear to be done with.
“Some of last year’s European stock market weakness can be attributed to a confluence of one-off events, from new emissions testing regulations and abnormally low Rhine river water levels in Germany to Italian budgetary woes and populist protests in France,” she said.
“These factors and their effects have begun to subside, which could prove positive for European stock markets.”
Another one-off factor that appears to have held back growth in 2018 was manufacturing companies de-stocking after accumulating large inventories in 2017, but recent data suggests stock levels are now back to desired levels – which means another constraint on growth may have been removed.
Finally, low unemployment in Europe is another positive for investors as it bolsters the economic outlook. European unemployment is close to historic lows, putting upward pressure on wages and helping to support household spending.
“More importantly, the direction of travel is towards continued strengthening: unemployment has not risen once since 2014,” the Heartwood investment associate added.
However, Howes also highlighted three reasons to be wary about Europe, starting with the risk that US president Donald Trump could look to target trade tariffs towards the region – especially on its important car manufacturing sector.
“Auto tariffs have already been threatened, although Europe has been quick to note that it would retaliate, and in any case there appears to be little support in US Congress for the tariffs,” she said.
“However, risks remain for the European auto sector, particularly with an unpredictable president who has made no bones about his dislike of Europe’s trade surplus with the US.”
Furthermore, Howes noted that slowing Chinese economy would have knock-on effects on Europe given the trade links between the two. The European manufacturing sector has already witnessed declines as Chinese growth faltered.
While Chinese authorities have taken steps to support the economy – which is the world’s second largest – the benefits have yet to show up in hard economic data. “A continued slowdown in China would certainly hinder European growth prospects, which in turn would spell bad news for European stock markets,” Howes warned.
The third reason to be cautious on Europe is one that no-one in the UK is likely to have overlooked: Brexit. The UK and Europe have close economic ties and the EU bloc is the UK’s largest trading partner.
A ‘hard’ Brexit, which is still seen as a possibility given the UK’s inability to discover exactly how it wants to leave – would have a “markedly detrimental” impact on an already fragile European economy.
Howes concluded that investors need to tread carefully when it comes to Europe as the economic outlook is so open to interpretation.
“Overall, we believe the domestic European picture continues to look relatively healthy, with positive labour markets and the potential for exporters to benefit from a weak home currency. We are also encouraged by signs that some of Europe’s previous hindrances to economic health are fading,” she said.
“Nevertheless, given recent deteriorating economic data and a lack of clarity around the effects of Brexit and a slowing Chinese economy, our portfolios maintain neutral exposure to European stock markets.”