Investor confidence has fallen to lows not seen since the very beginning of the coronavirus pandemic. This is unsurprising given the array of risks out there.
High inflation, rising interest rates and an escalation of the war in Ukraine are all combining to increase the chances of a recession in Europe. In 2022, European equity markets have fallen each consecutive quarter, making a loss of more than 20% since January.
In a market environment like this, investors tend to fall back on quality stocks with wide and narrow economic moat ratings. Looking ahead to the end of 2022, Morningstar equity market strategist Michael Field thinks the market is focusing too much on the short-term and is overlooking stocks’ long-term potential. Let’s have a look at the sectors in detail.
All Sectors Undervalued
Inflation is around 10% in European countries and is expected to stay high for the rest of winter. That makes protection a key theme for investors. In their ongoing fight to get inflation down to around 2%, we can assume central banks will continue to raise rates.
Investors now have to search for companies that can cope with inflation. In every sector Morningstar’s equity analysts find companies that are able to pass their rising costs and protect their profitability. These stocks offer upside potential, even from their current valuations.
Current valuations leave all eight sectors that Morningstar covers with upside potential relative to our fair value estimates, with 75% of the coverage in 4- and 5-star territory.
That is quite a different picture from last year, when half of Morningstar’s European equity coverage was fairly valued, and 30% was overvalued.
E-Commerce Opportunities
Opportunities can be found especially in the consumer cyclical sector, where 80% of coverage is rated 4 stars, and 60% is 5 star-rated. Looking at e-commerce, apparel stocks like Zalando (ZAL) and Inditex (ITX) are undervalued.
For food delivery, the pandemic helped companies attract new customers. But this year, rising interest rates, inflation and tighter capital markets for indebted companies have put pressure on share prices. Investors need to be selective and look for strong balance sheets, a clear path to profitability and resilient market positions as leader or second place player. Morningstar’s top pick in this sector is Just Eat Takeaway (JET), which has a 5-star rating.
Shift Towards Defensives
This year there has also been a visible shift from cyclical to defensive stocks. With growing uncertainty, investors have flocked to consumer defensive sectors and utilities.
Utilities are a good hedge against high inflation, especially with current skyrocketing energy prices. The sector suffered smaller losses than the broad European equity market this year and contains attractive dividend stocks. The current median trailing dividend yield is 4,7%, in line with the historical average. The top picks among utilities are Centrica (CNA), Engie (ENGI) and RWE (RWE).
Looking at consumer defensives, so far the big European grocers have been able to pass on their higher costs to shoppers. In the coming quarters that willingness will be tested further as the price of raw materials keeps rising.
Beverage companies have suffered no real damage from inflation so far, but that may change if European economies fall into recession. Brewer Anheuser-Busch InBev (ABI) is among the top picks, along with Barry Callebaut (BARN), JDE Peets (JDEP) and Unilever (ULVR).
Why is European Energy Undervalued?
In the energy sector the integrated oil majors Shell (SHEL), BP (BP.) and TotalEnergies (TTE) are still trading at significant discounts of 20-25% to Morningstar’s fair value estimates, even after recent updates. The comparison with US oil majors such as Chevron and Exxon, which are fairly or slightly overvalued, is remarkable.
One reason could be that in Europe the impact of sustainable investing is hurting Big Oil, with money flowing into funds that are underweight oil companies. And European investors are more doubtful about the renewable transition strategies of traditional energy companies. Their investment in innovation will take time and relies on financing from fossil fuel profits.
The record earnings have produced attractive dividends in the energy sector. Morningstar’s top pick is TotalEnergies. It doesn’t have the highest dividend yield at the moment, but the company has good upside potential given its strong balance sheet and cash flows.
