We have been positioned for this scenario, but admittedly too early, which is not unusual for a contrarian equity investor. The rotation out of US stocks into more fundamentally attractive and undervalued areas of global equity markets has seemingly commenced. At the moment, European equity markets seem particularly well positioned to receive the capital outflows from the US.
This article summarises our most recent observations on this topic and the implications for our global equity fund. Importantly, SKAGEN Focus has only about 10 percent of its asset base invested in US equities, due to valuation reasons, and around 40 percent exposed to highly discounted European cyclical investment situations. Moreover, the remaining part of the portfolio is concentrated in Japanese, Korean and Latin American markets which also trade at exceptionally low valuations compared to history.
An Extreme Starting Point
We have been through an interesting period – stretching almost 20 years – of US equities outperforming the European small and mid-cap complex. Valuation divergence between the two markets was also at vast levels, particularly for the largest US stocks, making it an unusual investment environment.
The valuation discount of European small and mid-caps to the Magnificent 7 is currently 56 percent on a P/E basis, double its 20-year average (28 percent) as we can see above, and the normalization potential seems vast as catalysts for The Great Rotation continue to emerge.
The very strong performance of European small and mid-caps versus US stocks from 2001 to 2006 may be a distant memory, particularly as they have since steadily underperformed over a staggering 20-year period.
The US
We believe the recent correction in US equity markets – the S&P 500 index fell over 10 percent from its February all-time-high – is due to a rapid increase in the political country risk premium of the equity market. The sell-off has been particularly painful for US mega-cap tech stocks, which entered the year with stretched valuations and very high expectations. Most indications suggest that Trump is willing to endure economic and market weakness in pursuit of long-term goals, such as tariffs and a smaller government. A wave of anti-US sentiment has been unleashed in Europe, Canada and most probably in many other countries. The US administration’s highly erratic and unpredictable policy communication, particularly around tariffs, is creating a vacuum that has caused paralysis among corporates and concerned investors about the negative impact on aggregated US earnings.
The equity markets are starting to anticipate a wave of downward earnings revisions or at least a slowdown in earnings momentum compared to the rest of the world, and in particular to European equities. Recent readings on consumer sentiment in the US has indeed been very poor. The close relationship between the leaders of the monopolistic tech giants and the US administration is highly problematic. If more ethical red lines are crossed, the pace of capital outflows from the US equity markets could accelerate. That poses a huge problem for global passive investors since the US country weight in the MSCI World Index just peaked at around 70 percent.
The Case for European Equities
You may remember Mario Draghi’s “whatever it takes” statement during the 2011 Eurozone debt crisis which paved the way for a gargantuan rescue package within the region. Using similar language, Germany’s new Chancellor Merz promised to do “whatever it takes” to restart and defend the European economy in this new political and financial landscape. The proposal, yet to be approved by the Bundestag, includes measures such as the exemption of all expenses in the German defense budget >1 percent of GDP from the national debt brake and the establishment of a special fund to fix Germany's outdated infrastructure, which will also be exempt from the current debt brake (EUR 500bn over 10 years). This is potentially a game-changer for Europe, ironically fueled and accelerated by the new policies of the US administration. It is worth pointing out that the US exceptionalism of the past decade is partly attributable to the country’s 7 percent deficit, while Germany’s is running at 1 percent. Now the US wants to cut its deficit, while Merz is seeking to increase Germany’s.
A ceasefire in Ukraine and peace dividend for Europe would also act as a powerful growth injection into European economies. We would expect the massive investment into infrastructure and defence to not only propel expansion in those sectors, but also awaken entire value chains across Europe, such as companies providing construction equipment, raw materials, steel and chemicals.
SKAGEN Focus
Our global equity fund SKAGEN Focus is well-positioned for the above scenario to play out over the next few years. We differ geographically from many other global funds due to our price-driven and contrarian investment process. Our exposure to the US is only about 10 percent, due to valuation rationales, compared to the global index (MSCI ACWI) which holds a weight of about 65 percent. Instead, we are holding a substantial share of the fund in heavily discounted smaller European companies and also similarly valued stocks in the rest of the world.
A few recently initiated companies in the fund are especially well-placed in this environment. Austrian brick and pipe producer Wienerberger would benefit from increased construction activity and the re-building of Ukraine in a post-war scenario. Overlooked German chemicals producer Wacker Chemie provides thousands of products for many industries, particularly the construction sector which generates a substantial part of revenues. Dutch Aperam and Spanish Acerinox provide stainless steel in Europe and would stand to benefit from increased demand from the defense and construction industries. And lastly, we have several construction machinery companies in the fund with large operations in Europe, such as Japanese Takeuchi and Korean Doosan Bobcat.
The Great Rotation in Motion
There are several indicators that a substantial rotation is underway in global equity markets that could potentially signal a larger shift out of US stocks into discounted and ignored equity markets overseas. Year-to-date the so-called Magnificent 7 are down 13 percent, the US equity market is down 4 percent while European equities are up 8 percent[1]. The vast amounts of capital invested into passive global equity mandates during the last ten years, which are yet to take notice, have the potential to accelerate the rotation. We believe the largest potential upside lies in small and mid-cap areas in Europe but also elsewhere outside the US, especially in the cyclical elements of the global investment universe. In this scenario, SKAGEN Focus is well positioned to generate value for our unitholders over the next few years.
[1] Bloomberg Magnificent 7 Total Return Index, S&P500 index, STOXX Europe 600, as at 14/03/2025.