Our Head of Research Product in Europe Paul Walsh and Chief
European Equity Strategist Marina Zavolock break down the main
themes for European stocks this year.
Read more insights from Morgan Stanley.
----- Transcript -----
Paul Walsh: Welcome to Thoughts on the Market.
I'm Paul Walsh, Morgan Stanley's Head of Research Product here in
Europe.
Marina Zavolock: And I'm Marina Zavolock, Chief
European Equity Strategist.
Paul Walsh: Today, we are 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 U.S.
How are you thinking about European equities versus the U.S.
right now? When we cast our eyes back to last year, we had this
surprising outperformance. Could that repeat?
Marina Zavolock: 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 U.S. 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 U.S. 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 U.S. on valuation.
So next one's P/E 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. So 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 percent.
Paul Walsh: Yeah, so there's a significant
discount. Now, obviously it's great that we are 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 U.S.; and the
perhaps not widely understood local currency outperformance of
Europe versus the U.S. last year. But do you think this is a
phenomenon that's sustainable? Or are we looking at, sort of,
purely a Q1 phenomenon?
Marina Zavolock: 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 [Q1] we saw this really big
diversification flow theme where investors were looking to reduce
exposure in the U.S., add exposure to Europe – for a number of
reasons that I won't go into.
And we're seeing deja vu with that now, mostly on the – not
really reducing that much in U.S., but more so, diversifying into
Europe. And the feedback I get when speaking to investors is that
the U.S. is so big, so concentrated and there's this trend of
broadening in the U.S. 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 U.S.?’ 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 [Q1]
phenomenon. [Be]cause that's exactly what it was last year. I
still struggle to see European equities outperforming the U.S.
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
U.S. I have 4 percent earnings growth forecast. That's driven by
some specific sectors. It's, you know, you have pockets of very
high growth. But still at a headline level, we have 4 percent
earnings growth on our base case. Consensus is too high in our
view. And our U.S. equity strategists, they have 17 percent
earnings growth, so we can't compete.
Paul Walsh That's a very stark difference.
Marina Zavolock: Yeah, we cannot compete with
that. But what I will say is that historically when you've had
these breakouts, you don't get out performance 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 could; you
can get out performance.
Paul Walsh: 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
benefits 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.
Marina Zavolock: I think the most important one
is AI adoption. 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 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 U.S. equivalent – 27 percent
discount. Also, if you see adoption broadening overall, and we
start to go into the phase of the AI cycle where adopters are,
you know, are being sought after and are seen as in the front
line of beneficiaries of AI. It's important to remember Europe;
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.
Paul Walsh: Understood.
Marina Zavolock: 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 you know, that comes after decade 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.
Paul Walsh: Yeah. And that could include
pensions reform across Europe, particularly in Germany, deeper
capital…
Marina Zavolock: We're starting to see it.
Paul Walsh: And 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?
Marina Zavolock: Within Europe, I get asked a
lot whether investors should be investing in cyclicals or value.
Last year value really worked, or quality – maybe they 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 S&P. And since
inception of top picks in 2021, European top picks have
outperformed the S&P 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 out performance.
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 semi's team who are quite constructive. Can
you tell us about the investment case there?
Paul Walsh: 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.
You have something of a memory supercycle 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 strong thematic overlay there as well.
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, we'll continue to be so, in the years to come. And we are
modeling a global Humanoids Semicon TAM 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?
Marina Zavolock: 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
models. 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.
Paul Walsh: 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 it's much more
complicated than that.
Marina, thanks for taking the time to talk.
Marina Zavolock: Great to speak with you Paul.
Paul Walsh: And thanks for listening. If you
enjoy Thoughts on the Market, please leave us a review wherever
you listen and share the podcast with a friend or colleague
today.
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