Unchartered waters. Volatility in Europe markets erupted in the wake of French President Emmanual Macron’s abrupt call for a snap parliamentary election, triggering fears of worsening political instability and an already ballooning fiscal deficit. The prospect of a far-right government, known for its protectionist policy stance and ambitious spending plans rattled investors, sending French stocks and bonds into a sharp selloff last week. Banks, widely seen as proxies for the economy given their sensitivity to economic cycles and sovereign spreads, suffered the most, while the broader CAC 40 Index suffered a loss of c.5% on a month-to-date basis.

Contagion risks unlikely. The retreat in French markets also triggered a selloff in the broader European region, leading to the Stoxx Europe 600 Index registering its largest weekly loss in months. Fears arising from unexpected political risks may have roiled markets, but we believe the sharp selloff was a knee-jerk reaction to a fleeting headwind, rather than a fundamental downgrade of the region’s outlook. Europe equities have shown resilience this year despite stagflation concerns, gaining 7.3% YTD while advanced GDP growth in 1Q24 surpassed forecasts. Commitment by the ECB to begin cutting rates around mid-year, ahead of the Fed, also attests to a positive growth environment for corporate earnings recovery.

France has some of the weakest macro fundamentals of the major European economies, complicating political agenda and increasing uncertainties. The point of stress for France lies in its excessive budget deficit of 5.5% (which is well above the EU limit of 3%), and its burgeoning public debt which has surged to more than 110% of its GDP. This is in stark contrast to the region’s largest economy – Germany – which is forecast to run a budget deficit of 1.75% this year, along with a national debt-to-GDP ratio of 63.6%. Despite pressure from the ECB, France continues to lag most other Eurozone economies in reducing its deficit, driving investors to steer clear of French debt.

Silver linings. Investor concern over France’s political woes should continue to subside, as attention reverts to economic data and central bank policies. In the near-term, weak sentiment will further compress equity valuations, which have already been suppressed near historic lows. Until we see a significant decline in bond yields or a substantial improvement in corporate earnings, the sustainability of gains in Europe equities remains in doubt. We maintain our underweight position on Europe equities, and highlight fundamentally driven sector-specific opportunities.

Given this period of heightened volatility, stay with European companies that exhibit strong fundamentals and growth prospects in the luxury, tech, and healthcare space:

Luxury: The luxury industry is anticipated to see a mid- to high-single digit CAGR over the next five years, with significant contributions from increasing affluence in Asia. Recent earnings highlight the success of dominant European brands in capturing the ‘quiet luxury’ movement – for instance, Hermès achieved notable double-digit growth in organic retail sales.

Tech: Europe is home to the world’s leading supplier of extreme ultraviolet light (EUV) lithography, a vital technology in enabling mass production of the world’s most advanced microchips. As companies and governments race to safeguard their supply chains and leverage on AI technologies, demand for such expertise will bring strong earnings potential.

Healthcare: Aside from its defensive nature which offers a hedge against macroeconomic downturns, extensive R&D in recent years by some of the world’s largest pharmaceutical companies, many of which originate from Europe, has produced a myriad of commercial-stage drugs which generate steady cashflow, followed by a pipeline of drug discoveries that offer compelling structural growth opportunities. As of 2Q24, Europe healthcare outperformed both the broader STOXX 600 Index and the US healthcare sector.