Welcome to Thoughts on the Market.
I'm Paul Walsh, Morgan Stanley's Head of Research Product here in Europe.
And I'm Marina Zavilak, Chief European Equity Strategist.
Today, we're here to talk about the big debates for European equities moving into 2026.
It's Friday, January the 16th at 8am in London.
Marina, it's great to have you on Thoughts on the Market.
I think we've got a fascinating year ahead of us and there are plenty of big debates to be exploring here in Europe.
But let's kick it off with the sort of obvious comparison to the US.
How are you thinking about European equities versus the US right now?
When we cast our eyes back to last year, we had this surprising outperformance.
Could that repeat?
Yeah, the biggest debate of all, Paul.
That's what you start with.
So actually, it's not just last year.
If you look since US elections.
I think it would surprise most people to know that if you compare in constant currency terms, so if you look in dollar terms or if you look in Euro terms, European equities have outperformed US equities since US elections.
I don't think that's something that a lot of people really think about as a fact.
And something very interesting has happened at the start of this year.
And let me set the scene before I tell you what that is.
In the last 10 years, European equities have been in this constantly widening discount range versus the US on valuation.
So next one's PE.
There's been, you know, we have tactical rallies from time to time.
But in the last 10 years, they've always been tactical.
But we're in this downward structural range where their discount just keeps going wider and wider and wider.
And what's happened on December 31st is that, for the first time in 10 years, European equities have broken the top of that discount range, now consistently since December 31st.
I've lost count of how many trading days that is, about two weeks.
We've broken the top of that discount range.
And when you look at long-term history, that's happened a number of times before.
And every time that happens, you start to go into an upward range.
So the discount is narrowing and narrowing, not in a straight line, in a range, but the discount narrows over time.
The last couple of times that's happened in the last 20 years.
Over time you narrow all the way to single digit discount rather than what we have right now in like for like terms of 23.
Yes, there's a significant discount.
Now, obviously it's great that we're seeing increased inflows into European equities so far this year.
The performance at an index level has been pretty robust.
We've just talked about the relative positioning of Europe versus the US and the perhaps not widely understood local currency outperformance of Europe versus the US last year.
But do you think this is a phenomenon that's sustainable, or are we looking at sort of purely a Q1 phenomenon?
Yeah, it's a really good question.
And you make a good point on flows, which I forgot to mention, which is that last year in 1Q we saw this really big diversification flow theme where investors were looking to reduce exposure in the US, add exposure to Europe.
For a number of reasons that I won't go into today,
And we're seeing deja vu with that now, mostly on the not really reducing that much in US, but more so diversifying into Europe.
And the feedback I get when speaking to investors is that the US is so big, so concentrated and there's this trend of broadening in the US that's happening and that broadening is impacting Europe as well.
Because if you're thinking about, okay, what do I invest in outside of seven stocks in the US?
You're also thinking about.
Okay, but Europe has discounts and maybe I should look at those European companies as well.
That's exactly what's happening.
So diversification flows are sharply going up in the last month or two in European equities coming into this year.
And it's a very good question of whether this is just a 1Q phenomenon, because that's exactly what it was last year.
I still struggle to see European equities outperforming the US over the course of the full year because we're going to come into earnings now.
We have much lower earnings growth at a headline level than the US.
I have 4% earnings growth. forecast.
That's driven by some specific sectors.
You have pockets of very high growth, but still at a headline level.
We have 4 earnings growth on our base case.
Consensus is too high in our view.
And our US equity strategists, they have 17% earnings growth.
So we can't compete.
There's a very stark difference.
Yeah, we cannot compete with that.
But what I will say is that historically, when you've had these breakouts, you don't get outperformance really, But what you get is a much narrower gap in performance.
And I also think if you pick the right pockets within Europe, then you can get outperformance.
So something you and I talked about a lot in 2025 is the bull case for Europe.
There are a number of themes and secular dynamics that could play out frankly, to the benefit of Europe.
And there are a number of them.
I wondered if you could highlight the ones that you think are most important in terms of the bull case for Europe.
I think the most important one is AI adoption.
Yes.
We and our team, we have been able to quantify this.
So when we take our global AI mapping and we look at leading AI adopters in Europe which is about a quarter of the index they are showing very strong earnings and returns outperformance, not just versus the European index but versus their respective sectors.
And versus their respective sectors.
That gap of earnings outperformance is is growing and becoming more meaningful every time that we update our own chart, to the point that I think, at this rate, by the second half of this year it's going to grow to a point that it's more difficult for investors to ignore.
That group of stocks.
First of all, they trade again at a big discount to US equivalents, 27 discount.
Also, if you see adoption broadening overall and we start to go into the phase of the AI cycle where adopters are being sought after and are seen as in the frontline of beneficiaries of AI.
It's important to remember the European index because we don't have a lot of enablers in our index.
It is very skewed to AI adopters.
And then we also have a lot of low hanging fruit, given productivity, demographic challenges that AI can help to address.
So that's the biggest one and the one I've spent most time on.
But let me quickly mention a few others.
M&A, we're seeing it rising in Europe almost as sharply as we're seeing in the U.S.
Again, I think there's low hanging fruit there.
We're seeing easing competition commission rules, which has been an ongoing thing.
But that comes after decades of not seeing that.
We're seeing corporate re-leveraging off of lows.
Both of these things are still very far from cycle peaks.
And we're seeing structural drivers which, for example, savings and investment union, which is multifaceted.
I won't get into it, but that could really present a bull case.
Yeah.
And that could include pensions reform across Europe, particularly in Germany.
Deeper capital markets here.
We're starting to see it in Germany.
In Europe as well.
Yeah.
And so, just going back to the base case, what are you advocating to clients in terms of what do we buy here in Europe, given the backdrop that you've framed,
Within Europe, I get asked a lot whether investors should be investing in cyclicals or value.
Last year, value really worked.
Or quality, maybe there will return.
I think it's not really about any of those things.
I think, similar to prior years, what we're going to see is stock level dispersion continuing to rise.
That's what we keep seeing.
Every month, every quarter, every year for the last couple of years, we're seeing dispersion rising.
Again, we're still far from where we normally get to when we get to cycle peaks.
So Europe is really about stock picking.
And the best way that we have at Morgan Stanley to capture this alpha under the surface of the European index and the growth that we have under the surface of the index is our analyst top picks, which are showing fairly consistent outperformance not just versus the European index but also versus the SP index.
And since inception of top picks in 2021, European top picks have outperformed the SP free float market cap weighted by over 90 percentage points.
And they've outperformed the S&P, this is pre-trade, by 17 percentage points in the last year.
And whatever period we slice, we're seeing outperformance.
As far as sectors, key sectors, banks is at the very top of our model.
It's the first sector that non-dedicated investors ask me about.
I think the investment case there is very compelling.
Defense we really like structurally with the rearmament theme in Europe.
But it's also helpful that we're in this seasonal phase where defense tends to really outperform between and have outsized returns between January and April.
And then we like the powering AI thematic and we are getting a lot of incoming on the powering AI thematic in Europe.
We upgraded utilities recently.
Paul maybe, if I ask you a question, one sector that I've missed out on in our data-driven sector model is the semis.
But you've worked a lot with our semis team who are quite constructive.
Can you tell us about the investment case there?
Yeah, they're quite constructive, but I would say there's nuance within the context of the sector.
I think what they really like is the semi-cap space, which they think is really well underpinned by a robust global outlook for wafer fab equipment spend, which we see growing double digits globally in both 2026 and 2027.
And I think within that in particular, the outlook for memory, something of a memory super cycle going on at the moment.
And the outlook for memory is especially encouraging.
And it's a market where we see it as being increasingly capacity constrained, with an unusually long order book visibility today, driven really by AI inference.
So a strong thematic overlay, And maybe I would highlight one other key area of growth longer term for the space, which is set to come from the proliferation of humanoid robots.
That's a key theme for us in 2025.
And of course, will continue to be so in the years to come.
And we're modeling a global humanoids semi-contam of over 300 billion by 2045, with key pillars of opportunity for the semi-names to be able to capitalize on.
So I think those are two areas where in particular, the team have seen some great opportunities.
Now bringing it back to the other side of the equation, Marina.
Which sectors would you be avoiding within the context of your model?
There's a collection of sectors and they, for the most part, are the culprits for the low growth that we have in Europe.
So simply avoiding these could be very helpful from a growth perspective to add to that multiple expansion.
These are at the bottom of our data-driven sector model.
So these are autos, chemicals, luxury, transport, food and beverage.
Most of these are old economy cyclicals.
Many of these sectors have high China old economy exposure as well, where we're not seeing really a demand pickup.
And then lastly, a number of these sectors are facing ever rising China competition.
And I think when we weigh up the skew of your views according to your model, I think it brings it back to the original big debate around cyclicals versus defensives and your conclusion.
That actually is much more complicated than that.
Marina, thanks for taking the time to talk.
Great to speak with you, Paul.
And thanks for listening.
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