European stockmarkets will bounce back

Investors in Europe are hoping that 2021 proves a duller year than 2020. Last year was one to forget, with the pan-European Stoxx 600 finishing down by 3.8%. The pain was not evenly shared. Spain’s IBEX finished the year down almost 15%, with France’s CAC falling by 7.1%. More happily, Germany’s Dax delivered a positive total return of 3.5%.

The MSCI Europe index, which includes British shares, posted its worst annual performance since the 1980s relative to the world average last year, says Morgan Stanley in a research note. European earnings may have fallen by 33%, more than double the global average of 15%. But a strong cyclical recovery is likely to take hold later this year, triggering a multi-year surge in profits. That should feed into stock prices, which closely track earnings trends – in 2004-2005, the last time the region enjoyed two successive years of 20%+ profit growth, the MSCI Europe index returned 33%.

European stockmarkets are a decent bet

The underperformance of European markets has little to do with geography and almost everything to do with sectoral make-up, says Richard Cookson on Bloomberg. Around 28% of large-cap US stocks are technology firms. In Europe that figure is 7%; in the UK it is just 1.5%. Almost 4% of the European market is made up of beaten-down energy stocks, compared to 2% in America. Indeed, if you correct for sectoral weighting, European and American stocks would have “pretty much the same valuation”.

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Surging tech stock prices and the rout in the energy sector have “whittled away” at that problem, says Buttonwood in The Economist. Tech firms now account for 14% of the Euro Stoxx 50, an index of eurozone blue-chips, making it the continent’s biggest sector.

That said, the case for European shares still rests squarely on the outlook for those hated “old-economy cyclical stocks” (banks, energy and industrials). A post-pandemic reflation trade should help them outperform over the next two years.

My worry is that we will get an inflation spike in major economies later this year, says Cookson. That could scare central bankers into hiking interest rates. If that happens then pricy US stocks would feel most of the pain, but European cyclicals would not be spared.

If interest rates and the dollar do rise, then European equities look better than the alternatives, says Buttonwood. Tighter global monetary policy would be especially painful for emerging markets, leaving Europe the “sounder bet”.

Fortune will “favour the brave” for European equity investors in 2021, says Rodney Hobson for Interactive Investor. The key is to look for “solid, boring companies that can stand the shutdowns” and are ready to profit once the recovery begins.