Equity Strategy Monthly: A Grinding Third Quarter Ahead

Further upside is limited, amid full valuations and an open-ended struggle to rein in inflation.

Michael Field, CFA 6 July, 2023 | 9:32AM
Facebook Twitter LinkedIn

Abstract graphic

European equities have risen to within a few percentage points of their fair valuations. The road ahead may be getting steeper. 

The second quarter saw markets tick upwards, recovering some of the lost ground from the March banking crisis and associated sell-offs, but the progress has been slow and gradual against the backdrop of a worsening macroeconomic environment.

Inflation is certainly falling-- slowly if you live in the UK-- but moving in the right direction at least. This has come at a cost: Interest rates stand at 5% in the UK and 4% in the Eurozone, the highest levels since before the global financial crisis. This is unquestionably having a negative impact on business, with the Eurozone already in a technical recession and the UK very likely to join it this year.

Revisions to GDP Growth Mean the Eurozone is Officially in a Recession

Chart showing the Eurozone in recession
Source: Eurostat. Data as of May 31, 2023

Yet, market valuations have been holding up despite the dark macroeconomic clouds, something we put down to investors leaning on the longer-term picture. We usually complain that the market is too short-term focused, but for once this doesn’t appear to be the case. Investors cling onto hope for an improving economic environment later this year or into 2024, when inflation may finally fall enough for central banks to take their feet off the interest rate accelerator. The danger here is that inflation could remain elevated for longer than investors anticipate, sending interest rates high enough to put the economy into tailspin.

Morningstar European Coverage Average Price/Fair Value Estimate by Sector

Price vs fair value plot 

Source: Morningstar. Data as of June 22, 2023.

Although European equities are very close to our fair value estimate, we see some clear opportunities in specific sectors. Consumer cyclicals, telecoms, and financial services are particularly unloved at the moment, while the European energy stocks remain at a discount to their US peers.

Thematically there are some bright spots too. Rising interest rates in the UK have not been kind to the country's homebuilders, whose stocks remain far below their 2021 highs. Investors are clearly worried about reduced demand for housing as the cost of borrowing increases, but taking a longer-term view, we see an ageing population and continued population growth as structural drivers of demand.


Housing Demand To Stay Robust As Population Ages

UK housing demand histogram 

Source: Office for National Statistics (UK), Morningstar estimates

Meanwhile, valuations are stretched in the insurance sector. My colleagues recently sought to answer the big question of whether the industry is next in line to suffer from rising interest rates, following banks' troubles in the first quarter. Its challenges include:

  • Rising number of claims
  • Rising cost of claims due to inflation
  • Interest rates reducing the value of their investments
  • Rising cost of debt

Although we don’t anticipate a major blow-up across the sector, we do believe that investors need to be more cautious than ever, paying particular attention to insurers' balance sheet robustness when picking stocks.

The Number of Natural Catastrophes and Damage Being Caused Continues To Rise

Reinsurance chart

Source: Swiss Re Sigma. Data as of Dec. 12, 2022.

Subscribe to Our Newsletters

Sign Up Here

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

Facebook Twitter LinkedIn

About Author

Michael Field, CFA

Michael Field, CFA  Michael Field is Morningstar's European Equity Strategist

© Copyright 2024 Morningstar, Inc. All rights reserved.

Terms of Use        Privacy Policy        Modern Slavery Statement        Cookie Settings        Disclosures