- Macro Strategist
Portugal, Institutional
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A sharp fall in gas prices, China’s reopening and slowing inflation meant European equities not only rose in absolute terms but also significantly outperformed US equities over the last six months. The path forward, however, remains uncertain, suggesting investors need to tread carefully and be selective.
Challenges ahead but a barbell strategy offers opportunities
European equities are structurally very cyclical and global markets face a range of cyclical headwinds:
- The lagged impact of tighter monetary policy — The world is currently experiencing a central bank tightening cycle not seen for decades. The lagged impact on global economic momentum of last year’s inflation-induced rate-hiking cycle remains uncertain. Looking at this in isolation, all indicators suggest that the lagged impact of tighter monetary policy is imminent in the form of a major slowdown, with real money supply (M1) growth pointing to significantly weaker purchasing managers’ indices (PMIs) and a still-deteriorating credit cycle.
- A continuing energy crisis — Europe remains in the grip of a severe energy affordability crisis triggered by the Russia/Ukraine war. Despite recent falls, current gas prices are multiples higher than the levels experienced prior to the conflict.
- Significant downside to earnings — European earnings are only just starting to see downgrades and global PMIs — a good indicator of GDP growth — point to more downside, as margins are close to an all-time high.
However, I expect European equities to outperform the US over the next three to six months. European equities experienced a period of record outflows throughout 2021, suggesting investors are very cautiously positioned. Moreover, there are several factors that could mitigate and delay the slowdown in growth. These include the persistence of an elevated volume of order backlogs, households continuing to sit on excess savings, the labour market remaining tight and a boost to growth from China’s reopening. Lastly, depressed valuations suggest European equities are already pricing for a fall in earnings.
I remain cautious on consumer and industrial cyclicals, outside of energy-transition plays, because I think they are pricing for an economic recovery that seems too optimistic. In contrast, European small caps offer a more attractive risk/reward outlook. They don’t appear to be priced for a sharp economic recovery and could benefit from the recent strength in the euro. In my view, the European banking sector is also attractively valued and should be able to deliver better earnings momentum than the market, despite the slowdown. Lastly, I think defensive areas within the European growth segment of the market (software, for example) offer potentially attractive upside after they underperformed on the back of higher interest rates.
More positive longer-term outlook but with key risks
Over the longer term (18+ months), the outlook for European equities appears structurally much better for three key reasons:
- A return to positive interest rates — European equities are structurally overweight value stocks, which benefited much less from the negative rate environment of the last decade than growth stocks. Especially for banks, this was a major headwind for profitability. The return to structurally higher rates should be a long-term positive.
- A shifting attitude to fiscal spending — Austerity following the global financial crisis was a major drag on European domestic demand. However, there are clear indications that this is shifting. The Recovery and Resilience Facility of the NextGenerationEU programme was funded by the first major issuance of European Union common debt, while the rules of the Maastricht Treaty are likely to be relaxed.
- Energy transition: the next super-cycle — While Europe had very little exposure to the tech super-cycle that drove equity markets over the past decade, a range of European companies are market leaders in important parts of the energy transition.
These three reasons suggest that European equity markets are unlikely to experience a repeat of the structural underperformance of the last decade.
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