Equities

5 Sectors to Invest in As European Equities Outperform US: UBS

  • UBS’s Nick Nelson believes that the market is “overly pessimistic” about European equities.
  • He’s not only optimistic, but believes Europe will outperform the US in the next six months.
  • Nelson shared his five favorite European sectors through each stage of the recovery.

Nick Nelson forecasts a brighter future for European equities in the coming months than current market consensus, which he deems “overly pessimistic.”

“2021 is set to show the highest operating leverage for European equities in 18 years and is one of the key positive drivers for the overall market,” Nelson, who heads European equity strategy at UBS, penned in a markets outlook published on November 8.

Recently, Nelson spoke to Insider about why higher operating leverage spells a warmer spring and summer for European equities than most investors are predicting, as well as the five sectors he’s most bullish on through the recovery. He also explained how European markets would outperform US markets over the short-term, but why macroeconomic factors favor US equities for the long-term.

Why is current consensus too pessimistic?

Nelson believes that consensus forecasts are too low given the current market conditions in Europe.

Operating leverage — measured as a company’s ratio of EBIT growth to sales growth — is most powerful in the first year of an economic recovery and then gradually fades as the cycle matures, says Nelson. He estimates this year’s operating leverage across European equities to be 4.3x, corresponding to an estimated 60% in EPS growth — around current consensus.

For next year, Nelson forecasts that operating leverage will fall to 1.8x, corresponding to EPS growth of around 15% — double the consensus of 8.6%.

“The bottom-up consensus has been bringing forward growth into 2021 and is now looking for very little to no operating leverage in 2022,” he wrote.

Nelson disagrees with that assessment because next year will only be the second year of the economic recovery. And even if operating leverage does fall next year, Nelson says low EPS estimates in Europe are overly negative.

Analyst consensus of just 8.6% EPS growth across European equities is largely due to the concern “that raw material and input costs are going to detract from companies’ profit margins next year,” he told Insider.

But Nelson says that companies have more gunpowder in their arsenal than investors are giving them credit for. “The key area where we’re different is we think corporates have pricing power where they can pass on these higher input costs to consumers,” he said, noting that European pricing power “is running close to a decade high.”

Nelson also believes that corporate margins are robust enough to weather analyst concerns.

Companies across Europe posted higher margins than expected in Q2, and the trend has continued through the Q3 earnings season. Consensus estimates versus the long-term trend “suggests that there is more to come from European corporates and that strong top-line growth in 2022 will deliver a second year of above-consensus EPS growth,” Nelson wrote.

“Additionally, the starting point for European corporate margins is relatively high compared to recent history — suggesting some resilience to external shocks,” Nelson wrote. He clarified that “external shocks” include higher costs, wage inflation, and supply chain issues.

As an example Nelson references the auto sector, which saw global production decline due to factors like the semiconductor chip shortage.

Nelson’s 5 winning sectors

With Nelson’s counter-consensus perspective in mind, which European sectors should investors target? 

In the short term, Nelson focuses on “the more cyclical and value-exposed sectors in Europe” — the ones most sensitive to an economic recovery. He favors the energy, construction, and auto sectors.

Over the medium term, or through 2022, Nelson is overweight healthcare.

“That’s obviously a more defensive sector, but at some point next year, recovery is going to slow,” he said. “Those stocks do better in that type of environment where you are moving more to a mid-cycle stage and growth. Healthcare is one of the large defensive sectors, which we think is the trap to be valued.”

Nelson is also overweight European financials in the short, medium, and even longer term — and he specifically likes the insurance subsector.

In the short-term, financials “are likely to benefit from both the economic recovery and slightly higher expectations for interest rates as those start to come through,” he said to Insider.

In the medium-term, strong growth would benefit “European financials that have high beta to growth, can tolerate a further rise in inflation, and also offer upside from a fundamental perspective,” he wrote.

“If the strength of the recovery and inflation surprise on the upside, consensus would need to significantly upgrade earnings,” Nelson continued. “If the view becomes one of higher inflation long term, it could also lead to investors paying more for bank’s earnings and to P/E re-rating, further boosting the upside potential for the sector.”

Regionally, Nelson is overweight Italy, Germany, and the UK. He thinks Germany has a cyclical advantage, while the UK is trading at a discount.

Nelson notes that some investors find the UK’s sector mix less appealing, since it’s lighter in technology and heavier in some older industries like energy, commodities, and banks. Still, “even if you adjust for the sectors and give it the same weight as the global index, it still looks cheap compared to where they normally trade.”

“So I think there’s a potential — if we see some catalysts — for that gap to close,” he added.

Europe will outperform the US, for now

Nelson says Europe is poised for a stronger economic comeback than the US because its


recession

was much deeper and its lockdowns seemed more aggressive.

Nelson also says that the European market “has higher exposure to the economic cycle” due to its sector mix.

Europe has steeper cyclical sectors, with more weight in assets like commodities, energy, and industrials, he told Insider. The US, however, is weighted far heavier in structural growth sectors like tech and software.

“Therefore, if you have a strong global recovery as we’re having right now, Europe is maybe better placed to take advantage of that,” Nelson said. “And there’s more geared into that in terms of earnings.”

The difference in timing for the economic cycle also plays a role in Europe’s outperformance. The European economic cycle is probably about a quarter behind the US’s, Nelson estimated to Insider. While earnings momentum peaked in May for the US, it didn’t peak for Europe until August.

“When we look at the relative earnings momentum of Europe to the US, which has been a key driver of performance, there has been some improvement in recent months during the recovery,” he wrote.

Nelson says that he has a higher price target on European equities than he does on the S&P 500 until the middle of next year.

“We think Europe outperforms the US over the next six months or so,” he told Insider.


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