Joining the party late – Europe’s bullish turn

Welcome to Beyond the Benchmark, the EFG podcast with Moz Afzal.

Moz Afzal:

Hi everyone. Today we have Gerry Fowler, who is head of European Equity Strategy at UBS. Gerry, welcome.

Gerry Fowler:

Hi, thanks very much for having me.

Moz Afzal:

So let's go straight to it. Like us, we recently turned more bullish on European equities and you’re also a lot more constructive as well. So maybe talk us through your thoughts on European equities, why you're bullish, what is the rationale for it?

Gerry Fowler:

Yeah. And to be honest, I'm not the most naturally optimistic person, so perhaps that needs to be caveated first, but I am now. So maybe that says something. Contrarian wise or momentum wise.

Moz Afzal:

I was going to say, something about European equity strategists tend to be a little more pessimistic.

Gerry Fowler:

It's because I come from a derivatives background, so the dopamine comes from chaos. So European equities. So we upgraded in large part because even if you were to look at the macroeconomic data, Europe doesn't look particularly compelling. Nothing really is changing. The economy is trundling along at modest but low growth. Inflation is fine. Obviously we've got the fiscal stimulus coming, but there's no evidence that it's coming out or hasn't been until very recently. So macroeconomically, many of the top-down strategists have had pretty sanguine views on Europe, and we have too. We had an internal discussion with our stock analysts. We've obviously got a big team at UBS, and it was very apparent analyst after analyst that the bottom-up story was quite different. The largest companies in Europe have changed very materially. It's now around about 45% of the market that adjust in the financials and industrial sectors.

And so they are doing very well, expanding their margins, growing their revenues. And therefore this year it looks like we might end up with about 18% earnings growth and potentially another 10 next year if consensus is right. So that's a stark contrast to the last three years. And what's driving that are a few things. First of all, Europe has plenty of companies that are contributing into the AI CapEx supply chain. Now, they tend to be quite late cycle. So we haven't really seen, in 2025 we didn't see a lot of momentum in Europe's AI enablement winners because they produce the cables and they produce the turbines and these sorts of things that actually go into the finished product of a data centre. They're not the GPUs, they're not the memory. Even ASML, it produces semis fabrication equipment, which you only need when you want to build a new semis factory, which is something that's only come up in the last six to 12 months.

So the earnings revisions have been very, very strong, particularly in that basket, but really only starting from the beginning of 2026 onwards. And in fact, the most recent earning season saw positive earnings revisions in those AI enablers that were twice as fast as they were, even though they were being revised higher quite quickly in the previous two earning seasons. So that's step one. Step two was that we're definitely seeing a broadening of the growth. It's not just those AI enablement winners that are growing or the banks that have been growing obviously with interest rates having gone up over the last several years. It's now broadening into lots more of the industrials, partly because there is a natural business cycle evolution in the US and in Europe where we're getting restocking. So we can see that finally, it's being reinforced in the PMIs. New orders are at their highest levels in multiple years.

That is probably just a standard business cycle, but it's also being enhanced by stimulus in both the US and Europe. So in the US, you've got the one big, beautiful bill that is encouraging manufacturing capacity. And Europe has suppliers of industrial automation and manufacturing equipment that will benefit from that. And in Europe, we've obviously got the German stimulus in defence spending and infrastructure spending, which has taken a while to get going. But we are now starting to see the cash flows coming out of the German government delivered into European companies. The orders are growing, and we do think there's going to be a decent acceleration in the earnings that come through through the rest of this year.

And then finally, the problem that Europe has had for the last couple of years, really the last decade or more, is that there's always been something going wrong. So 10 years ago, that was banks involved in multiple European crises. More recently, it's been things like the autos and luxury companies that have suffered from very weak Chinese demand. Last year, the market was being held back by not just the uncertainty, but also the real economic consequences of tariffs if you're an exporter to the US and a stronger currency because the euro appreciated about 15%. So there were quite a few stocks and sectors that were actually contributing negatively to European earnings growth. And finally, that's done. It looks like there are really no material sectors even down to industry groups that are going to be contributing negatively to European earnings, allowing the best to take the market forward.

Moz Afzal:

So just to maybe recap some of the key points there, the first is obviously the AI cycle and beneficiaries of that. I like the way you framed it in terms of late cycle within the AI sort of -

Gerry Fowler:

Joining the party. Joining the party at 10:00 PM.

Moz Afzal:

Exactly.

Gerry Fowler:

Or 12, depending on what we consider late nowadays.

Moz Afzal:

That's right. Spill over to 6:00 AM in the morning. But you've got the AI story, you've got the traditional economic cycle. And I think that's right. I think we're seeing that in PMIs in Europe, but in the United States and elsewhere. And Europe certainly is a beneficiary of that. And then the third point I guess critical is the fiscal infrastructure spending and the stimulus that is starting to weigh through. So you've got a very clear economic growth signals. Just maybe touching upon, I guess, the rate cycle. I think the key thing is that the rate cycle here feels like a mid-cycle rate cycle rather than we talked about economic late cycle, but the rate cycle seems to be, we've had one, we probably have maybe another at some point, but we're not going to have these continuous rate increases that will, or certainly not forecasted so far, that could slow growth into next year.

Gerry Fowler:

Yeah. When yields go up, they naturally will have a negative effect on asset pricing because they are effectively the discount rate. Now that's a combination of the government bond yields and also the risk premia, which we can see in credit spreads and obviously growth assumptions matter as well. Now, we saw most of the big bond yield rise several years ago, which was inflation led through Covid. Demand, but also inflation led. But because of the demand and the supply scarcity, the inflation that was coming through on energy and supply constraints was very easily priced. And so companies actually benefited a lot from that. So it's part of the reason why the last rise in bond yields, it hurt the valuation of the market, but the growth was so strong the market went up anyway after de-rating initially. This time what's happening, and it really started about six months ago, is that it's not inflation led, it's actually the real yield that is rising within the bond yield.

Now normally that goes up when growth is rising and there is an element of that. So like you said, there are elements of this that look a little bit like a mid-cycle yield acceleration because growth is accelerating. But I don't think growth is accelerating so broadly that the real yield would be going up the way it's been going up for the last six months. So then you fall back to the last reason that bond yields can rise. And that is because the investors who are buying bonds are simply demanding a higher premium for their capital. And that really shows that we've moved from an era really of the last 30 years of a savings glut to a savings scarcity. There is so much need for investment now or so much need for capital. Governments are running very big deficits. They require large amounts of capital to operate on their current structures, particularly in the US, but obviously plenty of countries in Europe are running large deficits as well, most notably France.

But also now there's so much investment going into AI and technology that you're getting big capital raisings from AI companies, from hyperscalers, from the industrials that are starting to supply that. So we're in this transition period where capital is becoming more scarce and therefore the cost of capital is going up. That is the definition of crowding out. So if you are one of the companies that has a strong balance sheet, strong cash flows, strong growth, you are making the most of the growth opportunities. You'll be fine. Your growth will comfortably offset the cost of capital that's going up, but it does constrain other parts of the market. So we think things like the consumer themselves as well as consumer companies, probably smaller companies, certainly low quality companies, will be the ones that start to feel the pinch from a rising cost of capital. We can already see that in things like private market spreads and defaults, as well as things like triple C spreads. But it's very early days. You really can't see this rising cost of capital particularly significantly anywhere, but we're definitely seeing evidence that it is something to watch in the coming year.

Moz Afzal:

Yeah, no, it's absolutely right. So let's look at it from a sector and then maybe geographical perspective. I think maybe just covering off the geographical part first in some points could actually be more easier. But we're seeing obviously this sort of German fiscal expansion that's kind of moving things forward. France a little bit more constrained, really can't do a huge amount. And obviously we've got elections coming up, so there'll be some uncertainty there. But I think probably the biggest story over the last few years has been how well Spain and Italy and some of the other countries that have been really on the periphery of Europe have really sort of come to the fore. And certainly Spain really comes to mind. A lot of solar energy and wind and so on and so forth have been sort of breezing through this period much better than some of the other European countries. But maybe talk us through that dynamic first.

Gerry Fowler:

Yeah. I mean, it's funny you say countries might be easier. The reality is European country indices are actually really just an amalgamation of varying sectors. So as you said in Spain, the bulk of the index capitalization and the company structures there are financial and utilities, mostly renewables with a few others. In Italy, you've got lots of banks as well as some utility companies, some energy companies. And it's been those type of companies that have been doing best. Banks obviously because bond yields went up and you've got some pretty bond yield and interest rate sensitive banks that dominate the markets in those countries. More recently because energy prices are up. So that not only helps energy companies themselves, but also renewable companies because they get to price their output, their energy off the gas price, which is the marginal cost of electricity. But in addition to that, the rescue and recovery funds that was set up as Europe's version of post - Covid stimulus was very much targeted towards renewable energy and electrification.

And the bulk of that money in notional terms actually went to Italy and Spain. Italy took quite a lot of its money in 23, 24. Spain started taking quite a lot of its share of money from that fund only in 25 and into 2026. So really it's a combination of the sector exposures and quite a lot of fiscal stimulus in key areas like renewable energy, utilities more broadly, financials that are supporting that, that have supported those markets and allowed them to outperform. Meanwhile, you've got headwinds for the core of Europe, like in Germany where the auto sector has been under a lot of pressure, both from weakness of demand around the world, but particularly China as well as EV competition and in France where the luxury companies have dominated. And they've also been suffering from weakness in demand, particularly in Asia, but to some extent more broadly as well.

Moz Afzal:

But let's talk a little bit about, do you think the auto sector in general starting to live, to get away from the past and now live the future, right? A little bit. There's a big change there.

Gerry Fowler:

Absolutely. It depends where you're looking. So within the auto sector, you could say that there are the auto makers and even there you've got luxury in Ferrari and to some extent Porsche. You've got the high ends of BMW and Mercedes, and then you've got the bulk makers. Then your suppliers and you've got tyre makers. So UBS, our analysts are pretty optimistic on particularly the tyre makers and also the suppliers because they are feeding into global supply chains with equipment that, for example, for the tyre makers, as we transition towards EVs, EVs tend to use tyres more quickly. So there is a volume argument there.

For the OEMs, it's definitely a lot more tricky. Within the broader OEMs, they've all suffered from weakness in Chinese demand because China has been transitioning towards more domestic supply, particularly of its EVs. And because China has gotten so good at EVs, partly because it owns its own battery supply chain and is fully. A lot of these car makers actually were born out of battery makers. So the engineering is very connected. The EVs are now being exported from China, creating a huge amount of competition for European car makers in other markets, most notably emerging markets where there are fewer tariffs and restraints on Chinese imports, but even in Europe. And the problem for the automakers is not just that they, European automakers, it's not just that they've been suffering on the volume side because of weakness in demand, but also in the transition to EVs. The EVs of European car makers are actually being sold at lower margin than their combustion engines. So the combination means that the European auto sector margin has gone down from sort of somewhere near 10% to about 4%. Just a huge destruction of earnings. And in fact, 2025 earnings were roughly the lowest they'd been in a decade, barring very briefly during Covid when cars couldn't be produced.

So there are expectations that those earnings bounce back pretty materially, but from a very low level, and it may not be enough considering the structural headwinds for that sector. So it kind of depends on which part of the auto sector you go to. I mean, there's an element of materiality too. I mean, the autos are now, I think, under three, maybe even two and a half percent of the index. They've just fallen so far. Very few people even want to discuss them. The constraints they've got is that they're facing competition that doesn't really care about profits because even within China, these automakers are so competitive with each other. They themselves have no margin.

Moz Afzal:

So moving on from that, some of the other sectors, obviously pharma starting to find some light after being in the doldrum for a very long time. What's your views on healthcare and pharma more specifically?

Gerry Fowler:

Yeah. So we had been pessimistic for a long while. I think it was about three months ago. We saw in some of the numbers that we run that the pharma sector obviously had cheapened and positioning had played out a lot. But what we usually look for is the driver of that weakness to abate. And the driver had been negative earnings revisions. Those did seem to be abating in that the market really just couldn't see a lot more downside. What was hurting them last year was partially tariffs, although that's a small impact on pharma. Definitely the currency because they generate a lot of their profits from the US and the euro dollar went up 15%. But particularly on the valuation side, a huge amount of uncertainty because of the policy that Trump was pursuing around most favoured nations alongside other things like tariffs. Now, there's been quite a lot of change.

There's been a lot of deals on drugs to go through the Trump RX platform, and it feels like the policy prioritisation of healthcare has dropped quite a lot. So we're seeing some risk premia recover in pharma. But in addition to that, special cases like Novo, which was a darling and the biggest stock in the market three or four years ago, it's had a terrible time because even though everyone can see the value of GLP-1s and the growth in volumes that was coming, there was a real uncertainty around pricing, which has been coming down, down, down, down, down. And finally, we got some news that Medicare was going to be reimbursing for GLP-1s, expanding the market by maybe 20 million users in the US, and also bringing in lots more private insurers who would be more willing to cover GLP-1s. So it moved the story from one of the top line revenue and the pricing of pharma back towards volumes.

Because we're in a cyclical recovery, defensiveness isn't really the trade du jour, but probably pharma is where we expect that we may see AI benefits starting to come through in profitability for companies using AI.

Moz Afzal:

Yeah. I guess knowledge work is the key word, right? So anything that is focused to that. Obviously banks, financial firms, pharma and biotech, all are huge beneficiaries of that. And I think your point with the defensive sectors is actually a very valid one. Of the defensive sectors, which ones do you prefer? Is it healthcare over utilities and consumer staples?

Gerry Fowler:

So in terms of the defensives that don't have structural growth, so within utilities, for example, renewables we really like, but to some extent they are more of a structural growth story than they are a defensive story. But for example, distributors and networks in utilities, we still quite like, but just are a bit more neutral on in comparison to renewables. So then in terms of the broader industry groups that a defensive pharma is absolutely the more defensive sector that we would prefer to own. We have actually recently taken consumer staples. So that's food, beverage and tobacco and household and personal products back up from least favoured to neutral. They seem to be recovering a little bit from the tariff and currency headwinds of last year. Lots of the pressure that they're experiencing on margins for various reasons, including energy. But we're not enthusiastic about them, not just because of the cycle, but also because of their just still quite sluggish growth and structural issues. So defensives is a bit of a tough place to be, but certainly within defensives, it's the pharma sector where we prefer to be.

Moz Afzal:

So it certainly makes sense. Kind of our view as well, certainly on our side. So on the industrials, obviously you've got the AI piece. So it's anything that's powering AI. As you said, we talked about late cycle. Any other sort of within the AI, I guess outside the semis, but any other parts of AI that you think are undiscovered relatively speaking?

Gerry Fowler:

I think most people are now pretty on top of the companies that are genuinely in that supply chain. There certainly has been an under talked about story relating to future data centre architecture. And what I mean by this is that at the moment, chips are being constructed with copper. But in the future, to make them more efficient and to have them run cooler, there is going to be a progression towards photonics. I mean, already photonics are an important part of data centres, but primarily in terms of things like fibre optic cabling that goes between the servers. But slowly that light connectivity, that photovoltaic connectivity is going to be getting closer and closer to the transistor itself. So as that happens, there's going to be an expanding market share for companies that can provide into that supply chain within data centre architecture. And there's going to be a renewal cycle of old chips being replaced with new chips as photonic chips start to develop.

So there are some companies in Europe that have some exposure in that space. It's easier elsewhere, like many of these themes, to find companies more closely associated to the theme. But within AI, I think that's an interesting theme where it might be possible to find some small European companies that could benefit from what I think is probably the hottest growth area within data centre architecture in the coming years.

Moz Afzal:

So what are your assumptions on data centre buildout?

Gerry Fowler:

In general, in Europe, the data centre build out is still fairly modest. There are lots of constraints around land costs, permitting, which can take four years. There are efforts to try and accelerate that. Energy costs being very expensive is additionally problematic for Europe at the moment. And even just energy supply, energy availability in Europe is constrained even without data centres, let alone data centre growth. So we don't have particularly significant expectations that data centre development in Europe is going to be driving domestic growth. Having said that, the news in the US, the mood music is shifting pretty rapidly where the politics is turning pretty hard against data centres and data centre develop in many states. Now, the US is a big country with lots of land, 50 states. So it may well be that that doesn't curtail the development, which is still in its early stages. But if it does, then there may be more reason for those companies to be looking elsewhere to try and find opportunities. I'm just not sure it's Europe with all of the constraints of Europe around power pricing, energy availability and network connectivity.

Moz Afzal:

Yeah, no, exactly. I think you're spot on. I think there hasn't really been the sort of divisions that came out from various policymakers a couple of years ago about how they wanted to build out data centres and AI. They've kind of got in their own way. Particularly with regulation, it just meant that permitting, for example, is a very, very good point.

Gerry Fowler:

And there is an optimistic story there. Yeah. I mean, the Draghi report is slowly being implemented, but Europe is so complex in its decision making. Trying to actually get something done requires a huge amount of political capital. And it's almost like the European policymakers from the commission down only really have enough energy to get one or two things done at a time. And at the moment, the priorities are defence and cyber and space. So once we tick off those three things, then there might be more room for Europe to prioritise a few extra things.

Moz Afzal:

Yeah. But to your point, there's a lot of interesting things going on in space. Europe is still well represented, I think, in those areas. And then I guess telcos at the margin, I always think of Europe as being a very heavy telco, or used to be, shall I say, maybe it's 20 years ago, very heavy telco listed companies. But that's kind of fallen away over the years.

Gerry Fowler:

A little bit. A very, very quick story there is just that because they're needing to spend less on their own capital expenditures to build out 5G or broadband, which is basically done now, there should be a surge in free cash flow, which we're seeing from those telcos. Historically, whenever they get free cash flow, they start price wars because it's a very competitive market. But the competitive environment in Europe is shifting. There seems to be more willingness from the European Commission Competition Commission to allow more mergers, for example, which might allow more pricing power. So while most investors still don't believe it, we do have some optimism that the growth in free cashflow and the distributions from telco companies can continue to expand quite nicely. But most people are too scarred from 20 years of intensive competition in that sector to believe it's going to happen this time.

Moz Afzal:

Yeah. I think I tend to agree with you. Before going to consumer, last on defence, clearly it's a sector that's got a lot of interest. Lots of people talking about it. Me personally, I'm a little bit more sceptical purely on the basis that constrained budget deficits mean that you're going to be much more aggressive on pricing even though you're going to spend on volume. How sensitive are these companies to volume and government contracts in the end ultimately is what drives it?

Gerry Fowler:

Yeah. So defence spending is tricky. For a long while now, it's been a fairly well-held, if not crowded basket of stocks. It's less expensive than it was, but it's still an expensive basket of stocks as well. That's not to say that they can't outperform. It's just if your starting position is everybody owns you and you're a little bit expensive, you really need to justify that with not just growth, but upgrades to growth. So that's part of the reason why they have not been outperforming. If anything, they've been underperforming for the last 12 months because every country got to a NATO target of 5% of GDP spending. So estimates couldn't really go up any further. And then there was this long wait for the spending to actually start to happen. Now, it does look like it's starting to come through a lot more quickly now, and hopefully that raises the optimism that the earnings can be delivered if not exceeded.

Then you just run into the headwind of Europe's defence companies looking a little bit like legacy defence companies producing aeroplanes and ships and missiles and things like that. Whereas actually we're seeing very clear evidence that the future of warfare might be a lot smaller and cheaper. So there's that headwind as well. We are back to a point where we are overweight, the defence spending beneficiaries, because we think the scale of money that's coming out will reinforce confidence. It is just one of those sectors where I think you've got to be a little bit stock specific. There's a good chance that the smaller companies in defence are a bit more nimble and able to expand and deliver what's necessary for European defence where there is going to be a high priority to spend. It's just a matter of who's actually going to be the beneficiary of that spending.

Moz Afzal:

Yeah, it's very, very nuanced. Tricky one. Very much agree with that. Yeah, it is a tricky one. So moving on to consumer. I think you said you're underweight in that sector. So just talk about your thinking there and logic. Is it all about China?

Gerry Fowler:

No, no, not at all really. I mean, for the luxury companies, it certainly has been a big headwind and they're just facing constraints from consumer demand globally. More broadly for the cyclicals, again, it was tariffs and currency last year that hurt them, but they're also just suffering from even domestically, a consumer that is very healthy with a high stock of savings and a pretty high savings rate, but just very low confidence. The Russia-Ukraine energy crisis that we saw four years ago saw energy prices skyrocket, therefore disposable income down sharply. Interest rates jump sharply, increasing mortgage costs as well as auto loan costs. And it really constrains the consumer and put them in a mood of, I'm going to hold back because I need to save for crises like these in the future. Now, it looked like we were starting to see consumer optimism come back as energy prices and bond yields started to come down early this year and we were getting more optimistic.

And then the Iran war really just threw a wrench in that. It's not the same scale, but again, energy prices are up, bond yields are up, consumer confidence is down. So we're of the opinion that until we can see a reversal of those three trends, the consumer is going to be a laggard in the market in terms of their demand. They're spending in supermarkets, they're spending on some clothes and some electricals, but they're not yet willing to take on debt to spend on cars, home renovations or homes. We're hoping that the industrial cycle breeds so much growth, potentially wealth as well, that you do end up feeding into a consumer recovery. But that's a second order effect, which we're going to need to wait and see. So in the interim, we just need to look for financials and industrials that we think can outperform as this industrial cycle gets underway. And then just keep an eye on some of those consumer companies for when the consumer feels a bit more confident.

Moz Afzal:

Yeah, because I guess valuations in those consumer companies are, I guess, at the bottom end of their historical ranges and positioning. So that certainly has an impact. Actually, one question I wanted to ask you was on, I guess the hope has always been, well, the American investor's finally going to look at Europe. Is there any evidence of that?

Gerry Fowler:

So US investors don't look internationally and country pick. If they're going to do anything other than invest in US equities, they usually just buy either MSCI World or MSCI World ex-US international funds. And it does look like they might be starting to do that because they can see that the cash flow that's being spent by the hyperscalers, for example, is going to. The beneficiaries are outside of the US, sometimes in Europe, often in Asia. So there is some momentum for US investors to seek investments internationally, but it's more tepid than we saw last year and certainly versus what we saw at the beginning of the year, which was really quite strong.

Moz Afzal:

Great. So Gerry, that's all we have time for today. Great. We got through a lot. So thank you very much for that, Gerry. Well,

Gerry Fowler:

Great. Thank you very much for having me.

Moz Afzal:

It was a pleasure. So with that, it wraps us up and we look forward to speaking to you again very soon. Thank you.

 

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