International exposure loses its appeal
Rising geopolitical tensions, trade wars and onshoring are major headwinds to globalisation. As geopolitical tensions and trade restrictions continue to increase, the share of international trade in the global economy could start to fall. Europe has been a major beneficiary of globalisation as its economies are among the most open in the world. International expansion and optimisation of supply chains were major drivers of profitability for European multinationals, especially in the aftermath of the global financial crisis (GFC), when European domestic demand was unusually depressed.
Now, however, Europe looks particularly vulnerable. For example, Germany’s current economic malaise can be explained to a large extent by its decade-long policy of favouring exports over domestic demand. As European companies adapt to this new, more fragmented environment, being an internationally orientated company may no longer be such a positive.
Investment implications — In aggregate, I expect domestically focused sectors and small caps to fare better than the major exporters, and periphery markets to continue outperforming their core counterparts. A second Trump term is likely accelerating this shift.
Intrinsically higher inflation and rates
In the decade after the financial crisis, central banks were able to keep monetary policy unusually loose for a given level of growth as inflation was virtually non-existent. Risk assets such as equities massively benefited from this continued policy stimulus, especially in the US.
However, I believe this is changing. Trends such as slowing globalisation, greater political intervention, continued fiscal expansion and global ageing are likely to lead to intrinsically higher inflation compared to the post-GFC period. At the same time, it is possible that Europe will feel the deflationary impact from AI later than the US (as regulation might slow the adoption of AI in Europe).
While European central banks have recently started to cut rates to support faltering growth, the structural shift in inflation means that any further rate decisions will have to be weighed up against Europe’s deteriorating growth and inflation trade-off. China exporting its overcapacity could provide a partial deflationary offset, but, on balance, I believe that inflation and rates will remain structurally higher.
Investment implications — The structural return to positive rates should be supportive for European equities relative to other regions but with certain areas benefiting more than others:
- Value stocks tend to be less sensitive than growth stocks to rate increases given that a large proportion of their cash flows are frontloaded. With the valuation gap between value and growth still extreme, I see major potential for value stocks with viable business models and reasonable levels of gearing. European equity markets are overweight value stocks.
- Incumbents also stand to benefit as higher financing costs could curtail further inroads by disruptors. Europe has very few disruptors but a large number of disrupted businesses. Low rates meant disruptors had access to cheaper funding and could stay disruptive for longer without having to turn a profit. However, higher funding costs would render many disruptors’ business models much less viable.
- Banks were particularly hurt by negative rates, which compressed their net interest margins, but this is changing. The valuation of European banks is not yet reflecting the sector’s improved profitability as leverage has come down and capital ratios are extremely strong.