- Macro Strategist
United States, Institutional
Change
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I believe that Europe is experiencing a regime change driven by a powerful combination of global and Europe-specific factors that could have significant implications for its financial and equity markets. In summary, I believe that:
- Europe will turn more domestically driven and interventionist, focused on a number of key priorities such as national security and digitalisation. The region’s growth and inflation trade-off is challenging but I expect rates to be structurally higher given stickier inflation and a greater willingness to support policy priorities through fiscal spending.
- From an equity perspective, I expect this to translate into a rotation from stocks with international exposure to more domestically focused companies — with periphery countries as the relative winners — and from growth to value stocks.
- Overall, I expect greater performance dispersion that could provide compelling opportunities for bottom-up, active investors. Below I discuss the key features of this regime shift, identify areas that may offer the most promising opportunities and outline potential portfolio positioning.
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.
A shifting attitude towards fiscal spending
For much of the post-GFC period, Europe focused on austerity measures, which acted as a major drag on domestic demand. Slowly, however, there is growing recognition that more coordinated fiscal spending is needed across a range of issues, including the energy transition, defence, deindustrialisation and digitalisation. Some examples of this ongoing shift include:
- Issuance of mutual debt — To support its economy post COVID, the European Union (EU) introduced the NextGenerationEU recovery plan. At the heart of the programme is the Recovery and Resilience Facility — an instrument for providing grants and loans to support reforms and investments in EU member states at a value of 723.8 billion euros. For the first time, the EU tackled an economic crisis with a major fiscal package lasting way beyond the original emergency. This money will flow until at least 2026 and, while a comparable successor programme is unlikely in the near term, we could see fiscal support for specific areas such as defence.
- More flexible fiscal rules — EU countries are required by treaty to keep their budget deficits within 3% of GDP and their public debt within 60% of GDP. However, the rules were recently amended to give countries more flexibility and time to comply if they reform their economy and support key initiatives such as the energy transition.
- More fiscal flexibility in Germany — The self-imposed debt break limits Germany from running a fiscal budget deficit bigger than 0.35% of GDP (outside of an external shock). However, I believe the debt break will be amended after the next German federal elections given the country’s growing investment needs.
A more interventionist approach driven by national security concerns
In contrast to the US, European politicians have rarely used “national security” as a driver of policy. However, supply chain issues during COVID, the energy crisis, Russia’s invasion of Ukraine and rising geopolitical tensions mean this is changing. Energy independence, robust defence capabilities, resilience of supply chains and access to key resources are now important policy goals for European and national policymakers. These new priorities are likely to translate into more interventionist policies, with major changes to subsidies and regulatory support for key industries.
Investment implications — This willingness to use fiscal spending along with targeted political and regulatory intervention will create winners and losers. Defence companies, telecom operators (the digitalisation theme) and electricity network operators (the energy transition) are potential beneficiaries of this trend. Defence companies are likely to be the most immediate winners, given the urgency of more NATO spending and accelerating efforts by the EU to strengthen the European defence industry.
Increasing impact of ageing workforce
Europe’s population is ageing rapidly, with Europe’s workforce expected to shrink over the coming years. This helps to explain why we see labour hoarding and strong wage growth despite a weak macro backdrop.
Investment implications — One key implication of the shift in demographics is increased investment in automation, efficiency and learning, which could benefit select companies within the capital goods and the software space.
Exposure to the next “super cycle”
While Europe has had very little exposure to the current tech super cycle, a number of European companies are market leaders in important parts of the energy transition. This transition is likely to propel what could be the next super cycle, driven by significant fiscal and regulatory tailwinds.
Investment implications — According to some estimates, 42 companies in Europe, representing around 15% of European stock markets’ cap, are leaders in the fields of green-related energy and sustainability. However, not all companies active in the wider energy-transition space are protected by high barriers to entry; for instance, companies supplying heat pumps and solar panels have proven to be vulnerable. This divergence between winners and losers should create a range of opportunities for active investors.
What does all this mean for positioning?
Europe’s regime change is unlikely to be a straightforward journey, creating risks but also outstanding opportunities for active investors. With that in mind, I would advocate a barbell strategy with the core focused on domestic cyclicality (companies exposed to European consumers, construction and banks) and earnings resilience, along with select exposure to the likely winners of Europe’s interventionist approach in pursuit of national security. Longer term, I would also encourage investors to keep a close eye on potential winners and losers of the energy transition super cycle and other key trends such as demographics that are reshaping Europe’s investment landscape.
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