Frédérique Carrier, head of investment strategy for RBC Wealth Management in the British Isles and Asia, looks at UK and European equities.

European and UK equity markets are trading at valuations which Frédérique Carrier at RBC Wealth Management believes are unusually attractive. 

Although she maintains underweight stances on both regions and thinks that index returns may remain muted until the end of the year, she sees compelling opportunities.

“With the UK’s Conservative government struggling in the polls, attention is turning to how Labour would govern the country. The next election is due by January 2025, but is widely expected to be held next year,” she said.

“The Labour Party appears to be focused on “making Brexit work” and on turning Britain into a “clean energy superpower” by 2030. The former goal suggests an effort to remove trade frictions, perhaps by achieving a relationship with the European Union akin to Norway’s,” she added. “This would require trust with the UK’s largest trading partner to be rebuilt first. As for the latter, Labour is promising to deliver new jobs and energy security by eliminating barriers to green projects,” Carrier continued.

“Should Labour win the next election, the new government will inherit a country with deep scars – not only from Brexit, but also from the Bank of England’s fastest monetary policy tightening spree in three decades,” she said. “Higher interest rates will be particularly painful for mortgage holders. According to data provider Moneyfacts, the average cost of a two-year fixed-rate mortgage rose to over six per cent this week, compared to roughly 2.25 per cent 18 months ago,” she added.

“Much of the increase in rates has not yet filtered through to the UK’s 7.5 million mortgaged households. That is because 85 per cent of UK mortgages are fixed-rate contracts, typically with terms of two or five years, unlike the usual 30-year term in the US. Therefore, interest rate hikes affect the economy only gradually,” she continued.

The BoE estimates that 2.1 million households will reach the end of their fixed-rate terms in 2023. Most of those have rates below 2 per cent, and could be renewed at rates up to three times higher. In fact, with market expectations of mortgage rates remaining above 4 per cent until the end of 2026, total mortgage costs could eventually increase by £12 billion ($15 billion) a year according to the Resolution Foundation, a British think tank. “Higher monthly financing costs are likely to negatively impact both consumer spending and the housing market – and improve Labour’s electoral prospects,” she said.

An internationally focused equities market
Carrier maintains her underweight recommendation for UK equities, but believes that there are opportunities in spite of the subdued outlook for the domestic economy. Thanks to a relatively high exposure to defensive sectors including utilities, healthcare, and consumer staples, UK equities tend to perform relatively well when global activity levels wane, as she expects will be the case later this year.

Furthermore, the pound peaking should remove a headwind to UK equity performance. The currency has rallied recently to 1.28 against the US dollar, but she believes it is likely to stabilise or even weaken going forward given that UK interest rate expectations are already aggressive and economic fundamentals are weak.

Carrier remains biased towards defensive, high-quality international revenue generators that trade at meaningful discounts to international peers. Her preferred defensive sector continues to be healthcare, although she thinks the valuation of consumer staples is becoming more appealing after a period of underperformance, and as the outlook for margins in the second half of the year has improved.

Stagnation across the Channel
Carrier highlighted how the eurozone has entered a technical recession after regional GDP contracted by 0.1 per cent in two consecutive quarters. While the outlook is muted, she thinks investors should not be too pessimistic. “Consensus expectations are for 0.6 per cent growth this year, and unemployment is at its lowest level in more than 20 years, at 6.6 per cent. Moreover, fiscal stimulus, while less generous than in recent years, should continue to underpin the economy,” she said.

Despite the challenges, Carrier believes that there are opportunities for the inquisitive investor. One interesting area, in her view, is tech: “A popular narrative is that Europe has low exposure to technology and is thus at a disadvantage, particularly in light of the buzz around generative AI. While European indexes have substantially lower weighting in information technology, there are opportunities connected to the infrastructure build required for generative AI.” She believes that leading semiconductor equipment manufacturers are particularly well positioned, as are select electrical equipment providers given that datacentres will require more power, smarter power management systems, and better cooling.

Carrier also likes luxury stocks that combine strong growth, brand and operational momentum, and reasonable valuations. However, she sees potential for greater variation in share price performance within the sector, given the bumpy China recovery.

Finally, she remains positive on the long-term prospects for European industrial stocks which she believes are well placed to benefit from capex spending connected to decarbonisation, automation, and onshoring trends. “The macroeconomic backdrop of both the UK and Europe is challenging, but many of the challenges appear to be already discounted in valuations,” Carrier said. She thinks that while returns on the broad indexes are likely to be modest for the rest of the year, there are compelling opportunities for investors willing to look deeper.