Now that the European economy is showing some strong signs of recovery, what does it mean for Europe’s equity markets? The European stock markets have roared ahead since the 2008-09 global financial crisis during a period of economic stagnation for Europe. Apart from the injection of cheap money, economic news has been mainly negative during the bull market. The euro-zone suffered a sovereign debt crisis, doubts emerged over the sustainability of Chinese growth, commodity prices collapsed and balance sheets were deleveraged – all this against the backdrop of anaemic economic growth.

Future economic prospects for Europe certainly look more positive with the oil price collapse and the weakening euro both providing strong tail winds for economic growth. European companies still face challenges in emerging markets whose economies have been adversely affected by a strengthening of the dollar and China’s structural shift from exports to domestic consumption. But the danger that China will end up exporting deflation if the renminbi devalues against the dollar has probably been ameliorated with the likelihood of further dollar rate hikes receding. Now that the European economy is showing some strong signs of recovery, what does it mean for Europe’s equity markets?

There are certainly plenty of opportunities for active managers to take strong stances. Views on the banking sector, for example, are highly polarised. It is true that profitability is being squeezed by higher capital ratios, tighter regulation and supervision, lower interest margins and the likelihood of losses coming out of the commodity and materials sectors as well as emerging markets. The newly enacted bail-in regime is also a source of concern for investors. But on the positive side, banks are cheap, they are progressively getting back to lending, and several leading players are well positioned to ride the new wave of financial technology (fintech) applications. 

It is not just the banking industry that needs to go through structural changes. The European pharmaceutical industry is arguably the most valuable part of Europe’s industrial base. But Europe faces some significant long-term challenges if it wishes to retain its pre-eminence in healthcare. Europe has not seen the plethora of small and mid-sized spin-offs and start-ups that characterise the US healthcare market. Are Europe’s large pharma companies thematically too diversified? Are there opportunities to invest in smaller companies emulating the US marketplace?

The problem for investors is that Europe’s equity markets may be a stockpicker’s paradise but many managers are still index huggers. Institutional investors in European equities clearly have a choice. They can go for cheap market capitalisation-weighted passive approaches; or more expensive smart beta, which improves on pure passive; or quant, which improves on smart beta. 

But if systematic alternatives can be bought cheaply, what can a fundamental active manager do that will improve returns? Typically, a fundamental approach can pick out problems in the balance sheet that a systematic approach may not be able to do. They may be able to have a forward-looking view that can take advantage of economic factors. What quant and smart beta cannot do is produce high-conviction portfolios with no more than 30-50 stocks. Conventional, high-fee, active fund managers with benchmark-hugging approaches will be the long-term losers in the marketplace for managing European equity portfolios.

While the European economy may be recovering, investors will not be able to extract much more beta return from the European markets. But, given the turmoil, there may be plenty of scope for alpha, providing they can choose the right managers. 

Joseph Mariathasan is an IPE contributing editor