Fidelity European Trust : Market volatility opens opportunities in quality European equities

Higher energy prices and shifting rate expectations have recently driven volatility in European equities, weighing on performance across quality-focused portfolios. Sam Morse and Marcel Stötzel, Portfolio Managers of the Fidelity European Trust PLC, outline how the team is navigating current market conditions and where selective opportunities are starting to emerge.

European equities started the year with stronger earnings and improving sentiment. That changed in March following the onset of the conflict in the Middle East as oil prices moved above $100 per barrel, pushing inflation expectations higher and forcing a reassessment of the interest rate outlook. For Europe, where energy is a major cost input, higher prices feed directly into margins, growth and consumer demand.

Markets have repriced quickly. Expectations for further rate cuts have been pushed back, with markets now pricing a higher for longer rate path. Cyclical sectors such as consumer discretionary have weakened, while energy has outperformed. Volatility has increased and stock correlations have risen, challenging the benefits of diversification.

Against this backdrop, the strategy has experienced a period of weaker relative performance. The portfolio declined over first quarter and lagged the benchmark, reflecting a combination of stock-specific setbacks and broader market dynamics. Exposure to companies affected by the evolving AI narrative, alongside weakness in selected holdings such as Novo Nordisk and Dassault Systèmes, weighed on returns.

This reflects a market that has favoured momentum over fundamentals, with quality and valuation discipline lagging, as seen in previous cycles.

Second order effects

It is important to recognise how rising energy costs are feeding into raw materials, transport and production inputs across multiple sectors. This is already visible in areas such as packaging, chemicals and fertilisers, where cost pressures are building.

The impact then moves to the consumer. European households were already facing pressure from higher borrowing costs. Increased energy and food prices reduce disposable income further, which in turn impacts demand. This is most pronounced in sectors such as retail, autos and luxury, where demand is more sensitive to pressure on household spending.

These dynamics are feeding through into markets. Consumer facing sectors have come under pressure, while energy and certain defensive areas have held up better. For the portfolio, this has created both headwinds and opportunities.

We have responded selectively to these developments. Energy exposure was reduced following the sharp rally, reflecting the view that much of the immediate upside had been captured. The portfolio also benefitted from holdings such as TotalEnergies during the initial move higher in oil prices, with exposure subsequently reduced as valuations adjusted. The Trust continues to run with modest gearing and maintains a cautious stance given the potential for higher rates to weigh on valuations.

Selective opportunities emerging

The core investment approach remains unchanged. Positioning continues to be driven by an investment approach that focuses on individual stocks, with sector exposures kept broadly balanced and changes implemented based on valuation and company fundamentals rather than macro forecasts.

We continue to focus on companies with strong balance sheets, consistent cash generation and the ability to sustain dividend growth. This discipline has historically provided resilience through more difficult market environments, even if it can lag during short periods where momentum dominates.

Within this framework, financials remain a key area of conviction. European banks are structurally stronger than in previous cycles, with improved capital positions and more resilient earnings. The current rate environment supports net interest margins, while valuations remain undemanding. This creates scope for both income and potential re-rating as confidence in earnings sustainability improves.

This is reflected through holdings such as the new position in BNP Paribas, where we see scope for improved returns as the European corporate cycle evolves. Elsewhere in the sector, we have exposure to Deutsche Börse, which has benefitted from higher market volatility and trading activity.

A more contrarian opportunity is emerging in airlines. Although higher fuel costs are an immediate headwind, periods of disruption tend to reduce capacity and improve industry structure over time. Weaker operators retrench, allowing stronger companies to gain share and improve pricing. This dynamic has been evident in previous cycles. We believe holdings such as Ryanair, with its cost advantage and strong balance sheet, are well positioned to benefit as capacity tightens.

More broadly, recent market weakness has created more attractive entry points in high quality companies where fundamentals remain intact. Many European businesses generate a significant proportion of revenues globally, providing resilience against regional pressures. At the same time, valuations remain at a meaningful discount to other major markets, offering a margin of safety.

The current environment is also reinforcing the importance of energy security across Europe. This is likely to accelerate investment in domestic energy capacity, including renewables and supporting infrastructure. Europe remains well positioned in areas such as grid technology and power equipment, which could benefit from increased capital investment as the region reduces reliance on external energy sources.

Near-term risks, long-term conviction

The near-term outlook for European equities remains uncertain with higher energy prices feeding through into inflation and interest rate expectations, as well as consumer demand. These factors are likely to keep volatility elevated.

However, the longer-term case for European equities remains unchanged. The region is home to a broad set of globally competitive companies with strong balance sheets and durable cash flows. Many continue to offer attractive shareholder returns and are well positioned to navigate a more challenging environment.

The recent pullback has created opportunities to invest in these businesses at more attractive valuations. Within the strategy, the focus remains on disciplined stock selection and a long-term investment horizon. While performance has been weak in the short-term, we believe the portfolio is well positioned to benefit as valuations adjust, and fundamentals reassert as the key driver of returns over time.