European equities outperformed their global peers over the past few months. But what are the reasons for this boom and what is the outlook for the rest of the year?
Since the end of last August, Eurozone equity markets have outperformed their global counterparts by around eight times – coming in at over 24% versus a global average of 3.3%. But why have EU shares been skyrocketing at a time when market conditions seem so adverse?
Should we be concerned that many EU stocks seem to be defying gravity? To answer this question, we have to look at the Eurozone in a global as well as local context.
The three main factors which have negatively impacted EU economies for the last year or so are: political instability, owing to the ongoing Russia-Ukraine war; a more than two-fold increase in wholesale oil and gas prices, driving up costs across the board for consumers and customers alike; and soaring inflation.
So why have Eurozone firms been outperforming their global peers so easily this year given the circumstances and what are the wider consequences for portfolio positioning?
The simple answer is that many of those negative impacts have been alleviated to an extent – in the short term at least…
Overcoming the key challenges… for now
Let’s take a look at oil and gas prices as a starting point. Although wholesale energy prices had more than doubled from the start of the invasion in March 2022 – as Russia sought to cut off supplies to its largest European customers such as Germany – prices have since reverted to pre-invasion levels from the all-time highs seen in September of last year. This has boosted market confidence as firms and consumers can adjust their fuel prices accordingly.
Now we can turn our attention to the situation in Ukraine. An invasion of its size hadn’t been seen on mainland Europe for decades, and the markets were rightly spooked as uncertainty took hold. That was over a year ago now the situation seems to have stabilised, with Russia’s invasion being halted by Ukraine and its allies’ efforts. Now that the situation has become more predictable, markets have responded by pricing in any potential developments, providing more stability to prices.
Thirdly, inflation – yes, it’s that word again. As central banks continue to raise interest rates in an attempt to reduce inflation back to its 2% target by the end of the year, European consumers are finally beginning to see a levelling off in prices as inflation begins to fall back to more reasonable levels. However, consumer confidence is still low and a slow-down in non-essential item purchases remains prevalent in the market. Whether or not central banks, including the Bank of England and European Central Bank, can achieve their ambitious inflation targets by year-end 2023, however, looks increasingly unlikely.
The drawbacks…
All sounds pretty positive, right? You’d be forgiven for thinking that, but if we take a longer term view, there are still risks weighing on the region, which could hurt its relative outperformance. Let’s take a look at some factors that may bring this temporary boom back down to earth over the coming months.
France and China
With mounting pressures at home and potentially abroad, President Macron has several big challenges for the EU’s second-largest economy looming in the year ahead. Firstly, his decision to bypass parliament to pass a controversial new pension age has been met with widespread protests and civil unrest, with a legal challenge on the horizon. Any further disruption to the French economy as a result could tip the country into a recession, with France having posted disappointing results for the last two quarters.
On the world stage, meanwhile, Macron, when meeting with Chinese President Xi, stated that France would not necessarily toe the line set out by Washington and much of the West in the face of further Chinese expansionism into Taiwan and beyond. This may have been made worse by the presence of Ursula von der Leyen and perceived by Xi as a more general European view of Sino-European relations.
Xi’s decision to end China’s no-covid policy has also given an unexpected lift to European – and particularly French – equities, as wealthy Chinese consumers’ demand for luxury goods soared. Whether this surge in demand is sustainable over the long-term, however, is uncertain; the spending patterns of Chinese consumers can be heavily influenced by the CCP policies – which are hard to predict. .Europe’s economy and stock market stands to benefit from any continuation in Chinese economic growth, though.
Investor overconfidence
A natural symptom of better-than-expected results amid general downturns can be that investors get overly confident and bullish in their forecasts and positioning. This could part way explain such a surge in European stocks of late.
This was reflected by the International Monetary Fund (IMF) revising down previously forecasted growth for the EU to just 0.7% for the year ahead. This is perhaps not surprising given the bloc outperformed expectations over the previous two fiscal years and growth is, of course, relative to size of GDP. If you compare Eurozone growth last year, at 2.6% expected and 3.5% actual, it makes for stark reading.
Financial sector contagion?
The fallout from the collapse of Silicon Valley Bank (SVB) in the States and the ongoing crisis at Credit Suisse in Europe cannot be underestimated. This ripple effect has already caused bank stocks in Europe and the US to plummet since March.
Although we believe that the overall financial system has proven to be solid, what the longer term consequences could be is harder to say given the financial sector’s relative complexity. However, given the interconnectivity of European financial institutions, it could have some level of economic impact in the coming year, not least from banks paring bank lending to businesses and individuals
The takeaway
In short, many European stocks have been the beneficiaries of fortuitous tailwinds causing them to see unexpected growth versus their global competitors.
We believe that European over-performance must be seen as the result of a series of tail-risk events (energy crises going out of control, escalation of the Ukraine crisis) that didn’t materialise. Other developed markets were not so exposed to these events, and therefore did not benefit so much as those risks receded. Moneyfarm’s more conservative positioning reflected this, with a higher weighting towards the US.
The fact that we seem to be experiencing an economic scenario that seems more stable than what we had anticipated is good news and this is somehow coherent with what we see in other regions. Looking ahead, though, while the outlook for Europe has improved significantly, we are still cautious in our positioning for two main reasons. The first is the war in Ukraine. This is by no means over and a new escalation could hit European equities the hardest. Also, if the likelihood of a recession continues to increase, US equities would likely offer more protection, just as we saw in March. As a result, for the time being, we have not changed our geographic exposure, although it remains one of the main focuses of our attention.
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