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The past few months have been characterised by a tempering of any enthusiasm over potential interest rate cuts. But in recent days central bankers appear to have softened their stance. For investors, any move on rates is likely to bring with it growing risk appetite. There is an argument that Europe could be in prime position to benefit.

In a recent report, Oxford Economics said businesses and investors may be underestimating the potential fillip to the global economy from a further easing in inflationary pressures and consequent rate cuts. It adds: “Against a backdrop of rising caution over the pace of central bank policy easing, our scenario analysis suggests faster-than-expected interest rate cuts would generate a gradual but sizeable economic boost. In our scenario, the rapid pace of policy easing fuels a rebound in capital expenditure and asset market gains.”

See also: Will bumpy inflation figures defer the interest rate cuts markets crave?

There are a number of markets that could benefit from this revived risk appetite, but Europe appears to be the early choice for investors. Europe is in prime position for a number of reasons. It is traditionally seen as a cyclical market, with a higher weight in more economically-sensitive industries such as industrials and luxury goods. It is also a natural choice for those looking to diversify away from the US, and the technology sector in particular.

There is also an argument that Europe may be the first to cut rates. The eurozone’s inflation reading was 2.6% at the end of February, which leaves it closer to the 2% target than either the UK or US. Last week saw a surprise interest rate cut from the Swiss National Bank. Although ECB chair Christine Lagarde has said the central bank is unable to commit to a particular path of interest rate cuts, other central bankers have been more optimistic. Greek central bank governor Yannis Stournaras said rates could be cut twice before the summer and four times in 2024 as a whole, while Finland’s central bank boss Olli Rehn has also been upbeat on the prospects for rate cuts.

Gareth Rudd, manager on the Chelverton European Select fund, adds that rates don’t necessarily need to be cut for sentiment towards European equities to return: “It is clear that this is nearer the top than the bottom. I don’t think they need to come down for confidence to return. Interest rates at 5% is not an egregious level relative to history and companies can live with that”. He points out that leverage levels for European companies are not that high.

Fund flows

There are signs that investors are returning already. The latest Investment Association figures showed a marked slowdown in outflows from Europe ex UK funds in January. Having seen outflows of £2.8bn in 2023, there were outflows of just £20m in January and the European Smaller Companies sector saw a small inflow. The Bank of America’s closely-watched fund manager survey found that fund managers have performed the biggest rotation into European stocks in almost four years over recent weeks, while Calastone showed investors increasingly directing capital towards European funds, and ESG-focused funds in particular.

See also: Lipper report: European investors ditch active funds for ETFs

Helen Jewell, chief investment officer, BlackRock Fundamental Equities, EMEA, has also highlighted European equities as an area to watch over the next few months. She said: “European equity markets have reached record highs this year – yet remain at a historically wide discount to US stocks.”

While she doesn’t see the gap closing in full, she sees three reasons why it may narrow in the medium term: “The economic environment in Europe is improving with economic activity picking up and energy prices stabilising, creating a more supportive backdrop for European equities. This is bolstered by strong consumer savings and wage growth, enhancing consumer spending power.

“Second, the potential for rate cuts by the European Central Bank, in response to inflation falling closer to its target, hints at a more favourable climate for European stocks, especially benefiting small- and medium-sized companies with higher debt levels. Lastly, the resurgence of buybacks as companies purchase their own shares at attractive prices promises an additional return avenue for investors, particularly as some European banks are poised to return significant capital to shareholders.”

European equity performance

Performance has already picked up. The Europe ex UK sector is the seventh best-performing sector for the year to date – with Japan and North America the only regional markets that have outpaced it. Rudd believes there is a strong case for European equity markets – and smaller companies in particular as confidence returns. He adds: “There has long been a divergence between what the market is doing and the level of share prices. Global markets have been very narrowly-led, it’s not a surprise that people are looking more widely.”

He is encouraged by the pick-up in corporate and private equity buyers for European companies. He has seen three bids for companies in the portfolio since the start of the year, and seven in the last 12 months. “Valuations are too cheap and private equity has lots of capital to deploy. The market hasn’t wanted to know about smaller companies because they have been seen as vulnerable to interest rates and inflation, but now there are still some really good companies trading at low valuations.”

There is also the issue that European capex has been absorbed by Covid, inflation and re-engineering supply chains. As the effects start to ebb, companies can start to spend on different, and more productive, capital expenditure. This could also boost investment activity across the region.

There are caveats. The eurozone economy still looks relatively fragile and if the ECB stalls on interest rates, markets may not take it well. Any wobbles on inflation would be a risk to sentiment. Nevertheless, for the time being, Europe appears to be the ‘risk on’ market of choice.