European equity markets have performed roughly in line with global markets since January 2019. This dovetails with our neutral regional ratings for the euro area, Switzerland and the UK, which offer good but not exceptional prospects for equity investors.
We observed a low level of return dispersion both across countries and sectors in Europe since the start of the year. This underscores the fact that the shift in Fed monetary policy at the onset of this year provided the key driver for the present European equity recovery, which bucked the trend of decelerating manufacturing activity.
The latest manufacturing PMI for the euro area showed a slight dip, from 47.9 to 47.7, providing another hint that the manufacturing growth slowdown might be nearing its trough. The industrial cycle seems to be troughing in France and Italy, while the German manufacturing sector remains under pressure as the latest Market PMI and German Ifo indices for May have not bottomed yet.
Among major European countries, only Spain lagged by a significant margin. The large weight and the weak performance of its banking sector took their toll on Spanish equities. At the sector level, European banks, as anticipated, were consistent underperformers, followed at some distance by materials companies which lost ground in the past weeks as the trade war intensified. Investors were able to eke out a slight outperformance by overweighting information technology and consumer staples stocks.
We consider the European information technology and the healthcare sectors as two of the few market segments able to deliver robust long-term growth. We reiterate our negative view on the European banking sectors in spite of its low valuations. Low bond yields, flat yield curves and pedestrian GDP growth create significant headwinds for banks, even if loan growth looks solid in France and Germany. We maintain a defensive stance on Italian banks, especially if the spread between Italian BTPs and German Bunds widens in the wake of the European Parliamentary elections.
Our general preference for large-cap growth companies amid a sluggish global growth environment also applies to Europe. Companies blending growth and quality probably offer the best prospects of outperformance in Europe. European equity markets offer many value stocks, but we believe it is largely premature to buy European companies on value grounds only, as many of these companies (e.g. banks, auto makers) face structural challenges over the long-term which warrant low valuation in most cases.
Companies with medium-sized capitalization (mid-caps) have underperformed since mid-2018. If the manufacturing cycle strengthens as anticipated in H2 2019, we forecast renewed outperformance of European mid-caps in H2. European mid-cap stocks have delivered a steady source of outperformance since 2000, unlike small caps. European mid-cap companies have often been able to reap benefits from globalization and to outgrow their local economies, while small caps have struggled since 2008 as European domestic demand has expanded only modestly.
We feel that the valuation of European equities with a P/E ratio of 13.3 is appropriate, being neither expensive nor unusually cheap and reflecting low government bond yields and a dearth of alternative investment opportunities in Europe. Investors focusing on dividend yields should note that the highest yielding equity markets are Italy, Spain and the UK.
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