European equity markets bounced back somewhat from the sell-off in April as hope waxed and waned for an end to the conflict in the Middle East.
The key concern for economies and markets in Europe and Asia is the impact a prolonged closure of the Strait of Hormuz would have on global supply of oil, gas and downstream products and the price & demand destruction that a continued supply disruption would cause.
However, there are/were further factors at play in markets that we think are more important, namely the continued outperformance of anything related to capital expenditure by technology hyperscaler companies (including Amazon, Google, Microsoft) and electrification (semiconductor capex, power semis, electrical equipment and other datacentre providers) and the continued underperformance of pretty much everything else, but especially stocks sensitive to the consumer, with banks broadly in the middle.
We would not characterise this as a bubble in the making – at least not a valuation bubble – as the outperformance is reflective of earnings growth AND earnings revision trends whilst consumer sentiment remains fragile across many parts of the world. In short, we do not believe the market is acting irrationally.
Muted reaction for banks
The only area we are slightly surprised by is the bank sector, where another set of outstanding results has not generated the level of share price reaction that we would normally expect and where many of the stocks are trading at valuations implying a Return on Tangible Equity (ROTE) far below that being earned at the current time, and likely ROTE in years to come (still rising).
If you look at an earnings revisions chart for Caixa Bank for the years 2024, 2025, 2026, 2027 and 2028, what is clear is that the market has continued to underestimate the earnings power and earnings growth of this business (and many other banks). As long as that continues, we expect to see strong outperformance from this sector.
Scaling the extent of the hyperscaler companies’ investment opportunity and the associated spend on semiconductors, semiconductor capex and associated electrical equipment spend is difficult, and we claim no particular expertise in answering this question other than observing that for the US and China this is a form of economic warfare to gain the leading position in technologies that may dominate the 21st century.
Semis bubble?
Both countries are “all in”; we do not know whether this will lead to a bubble as we do not yet know how aggressively AI use cases will scale, but we can see that in many domains across industrial services, manufacturing, defence, financial services etc, there are both extensive possibilities and vast amounts of data to feed AI models and processes.
We feel more confident in the trajectory and growth of electrical investment as the case for this is well beyond AI spend and includes decarbonisation and the growth of replacement technologies such as EVs, heat pumps and changes in electrical processes. For that reason, in our European equities strategies we retain a large exposure to electrical spend through Siemens Energy, Schneider Electric, Prysmian, and Infineon, where the market continues to underestimate the growth.
Electricals underestimated
In our European equities strategies, we are modestly underweight semiconductor capex on valuation concerns and risks around the US further restricting China purchases, but this may be too pessimistic – irrespective, our overweight in electricals more than compensates for our underweight in semiconductor capex, and we will change course if we think we are wrong. The market has continually underestimated the earnings growth of Prysmian, something we have partly done ourselves, although we have retained a significant position.
On the consumer side, luxury stocks continued to largely underperform as Q1 results were not enough to catalyse the sector or change views that the outlook remains tepid for luxury spend. More broadly exposed consumer staple stocks have also continued to perform very poorly with a handful of exceptions – L’Oreal, Nestle and AB Inbev – reflecting tough consumer sentiment, low growth, and continued earnings disappointment.
We are not convinced this sector is particularly cheap and in addition to the cyclical pressures there are well known structural pressures that are also acting against the stocks such as GLP-1 drugs (Wegovy, Ozemic for weight loss) facing private label competition, falling alcohol consumption, demographics etc, and some are beginning to question whether the traditional consumer staple model built on mega brands is simply less relevant in today’s world.
Strategy risks
- Currency (FX) Risk - The strategy can be exposed to different currencies and movements in foreign exchange rates can cause the value of investments to fall as well as rise.
- Share Class Hedging Risk - The share class hedging process can cause the value of investments to fall due to market movements, rebalancing considerations and, in extreme circumstances, default by the counterparty providing the hedging contract.
- Pricing Risk - Price movements in financial assets mean the value of assets can fall as well as rise, with this risk typically amplified in more volatile market conditions.
- Market Concentration Risk (Geographical Region/Country) - Investing in a particular country or geographic region can cause the value of this investment to rise or fall more relative to investments whose focus is spread more globally in nature.
- Derivative risk - the strategy may use derivatives to reduce costs and/or the overall risk of the strategy (this is also known as Efficient Portfolio Management or "EPM"). Derivatives involve a level of risk, however, for EPM they should not increase the overall riskiness of the strategy.
- Liquidity Risk (general) - During difficult market conditions there may not be enough investors to buy and sell certain investments. This may have an impact on the value of the strategy.
- Counterparty Default Risk - The risk of losses due to the default of a counterparty on a derivatives contract or a custodian that is safeguarding the strategy’s assets.
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