Aaron Barnfather
As Europe enjoys summer, it does so in the knowledge that European equities performed solidly over the first half of 2023.
Not all good things last however, and European equities may struggle over the near term as the effects of higher rates begin to bite. When compared to their counterparts across the globe however, European stocks arguably look relatively better placed to withstand a potential global slowdown, despite the region facing major economic headwinds. Heavily inverted European and UK yield curves continue to point to a recession in both the eurozone and the UK, but higher bond yields mean European fixed-income investors can pick up attractive yields for modest risk. We suggest steering clear of riskier high-yield debt at this time.
European equity
Long days of golden sunshine and warm temperatures boost the mood of all but the most curmudgeonly soul. Yet, on the cusp of the holiday season in the northern hemisphere, it is not just the prospect of setting out-of-office messages ahead of poolside-lazing and beachbathing that will have many European equity investors in good spirits. They can also cheer a solid six months for European stock markets: the MSCI Europe Index delivered a total return of 14.2% in euro terms over H1 2023.
A largely resilient European economy has helped underpin this decent showing. Feared economic disruption caused by potential energy shortages never materialised, thanks to a mild winter and effective stockpiling of natural gas. And although the eurozone economy is now technically in recession following its -0.1% contraction in Q1 2023 and Q4 2022’s revised -0.1% GDP print, there has been scant evidence of any hard landing thus far in this unprecedented rate-hiking cycle. Meanwhile, inflationary pressures across the Continent and robust corporate earnings have given investors further reasons for optimism.
Hikes start to bite
Despite this generally benign scene, we continue to believe that caution should prevail. European equity markets look too sunnily disposed, in our view, given the macro backdrop and the lagging effects of monetary policy tightening. To explain our ongoing wariness, let us briefly recall the past few turbulent years through the lens of monetary policy.
The European Central Bank’s (ECB) response to the COVID-19 induced economic coma was a major increase in the money supply. M3, a measure of broad money including short-dated debt and deposits, grew by 12% year on year in December 2020, more than double December 2019’s figure (although well short of the 25% explosion in the US money supply over the same period, as measured by M2). Soaring inflation forced the ECB to follow with the most aggressive rate-hiking programme in its history, and it is not done yet.
Having thrashed the accelerator, the central bank is now stamping hard on the brake. The stimulative effects of the pandemic-driven money supply expansion are petering out just as multiple interest-rate hikes begin to bite in the real economy.
Our recent research meetings have tentatively suggested that these rate rises are starting to hurt corporate activity, whether it has been a construction company warning of project delays, a chemicals company reporting destocking in building supplies, or signs of a slowdown in infrastructure, especially in the US where the after-effects of the regional banking crisis are still being felt via tougher credit conditions.
There has already been a steady deterioration in the manufacturing sector over the past year, with the eurozone manufacturing purchasing managers’ survey remaining below 50 (indicating contraction) throughout the past 12 months and slipping to 43.4 in June.
Respite had been provided by the larger services sector, however. It has been buoyant, helped by post-pandemic catch-up consumer spending. But while the divergence in manufacturing and services activity levels—a pattern also recently visible in the UK and US economies—persists, services sector activity has apparently softened in the past two months, with the eurozone services purchasing managers’ survey edging lower to 52.0 in June, down from 55.1 in May.
Elsewhere, the recent revival in European consumer confidence stalled in May although improved in June. And while wages have been growing (+4.6% in Q1 2023), most consumers will still be suffering from smaller pay packets in real terms, given the annual eurozone consumer price inflation rate currently stands at 5.5%.
With the ECB still pumping the brakes hard, and the impact of earlier rate rises now being felt in the real economy, we believe a material slowdown in short-term economic activity and further weakness in the money supply seems highly likely—the latter is visible in the latest M3 data, which showed a 1.4% increase in the broad money supply growth year on year in May, the lowest rate of expansion since July 2014.
Brighter notes
European equity investors should therefore be braced for tougher times over the next few quarters. But we see reasons why Europe could be relatively resilient versus other major developed markets.
First, European earnings have surpassed expectations. The region has led the international pack over the past 12 months on earnings revisions.
This earnings strength may partly reflect the different mix of businesses within the European market, particularly in comparison to the more technology-biased US market.
European indices have a far greater weighting in financials, which have benefited from higher rates leading to earnings upgrades, while the Continent’s heavily regulated banks have been unaffected by the regulatory issues that have undermined bank stocks in other regions.
The solid earnings story also reflects the quality of Europe’s leading industrial names. They continue to enjoy healthy order books, fuelled by a wave of post-COVID investment and reshoring as companies fix brittle supply chains exposed by the pandemic.
This reshoring drive has meant European industrials have proved less sensitive to the stuttering post-Covid Chinese economy than otherwise might have been expected. Finally, European consumer demand has held up better than anticipated as the pinch from higher energy and food prices has eased.
Second, despite the relative outperformance of European indices versus US indices over the past year —which narrowed over Q2 2023)—and the robust earnings posted by European firms, the longstanding valuation discount to US markets has not budged. Global investors continue to look at the European market with either indifference or mild reticence, with flows into European equities being negative so far this year.
European equities still appear to be underappreciated.
Third, the breadth of Europe’s market strength compares favourably to the narrow leadership of the US market. The equal-weight version of the MSCI USA Index underperformed the market cap-weighted index by over 8% over H1 2023, as most of the US market’s gains came from a select group of predominantly mega-cap technology companies.
Significantly more European names than US names have outperformed a relevant index, suggesting the European market currently enjoys sturdier foundations.
AI: Europe has a seat at the table, too
Before closing the equity section, given the huge focus on AI in recent months, we would like to briefly touch upon what this powerful, society-changing trend might mean from a European investment perspective.
The market has proclaimed US and Asian tech giants as the future winners from AI’s exciting growth trajectory. In doing so, Europe has been overlooked, despite the region being home to some of the world’s best semiconductor equipment manufacturers.
These corporate leaders are poised to gain from increasing investment in semiconductor capacity. Europe also boasts a range of first-rate software and content companies that can use AI to enhance their offerings.
Lastly, European construction companies are well placed to meet the demand for building and insulating server farms.
AI will, of course, have long-term consequences for job security in certain fields. But strictly from an investment standpoint, its seemingly inexorable rise could provide a significant through-the-cycle investment tailwind for several European-based firms.
In summary, we believe European equity investors should be cautiously positioned in the months ahead as the squeeze from higher rates intensifies.
The European economy has been resilient to date, but the probability of this still ongoing fast-paced series of rate hikes ending in any scenario other than a marked slowdown seems low. The recent loss of momentum in the previously buoyant services sector suggests the ECB’s monetary medicine may be taking effect.
Nevertheless, with European earnings outpacing other developed markets, the US stock market’s dependence on a narrow band of names for leadership, and European equities remaining cheap on both a historic basis and relative to US equities, there is a credible argument to be made that Europe is better placed to ride out the next few quarters as the cycle likely worsens. Meanwhile, we will seek to add value through prudent stock picking, even as the region’s economic headwinds become more pronounced.
The spread between the highest- and lowest-rated stocks recently widened again. Therefore, we anticipate plenty of valuation anomalies to exploit through our disciplined relative value approach.
By Aaron Barnfather, Managing Director, Portfolio Manager/Analyst
