LONDON, May 2 (Reuters Breakingviews) - European shares have been on the rise for seven months, outshining their U.S. counterparts, and are now just 6% below their record high. Yet the region’s companies are running out of puff. An unprecedented bout of rate hikes will erode profits, margins and demand. The bloc still looks cheap, but for good reason.
Investors in Europe have had an uncommonly good time of late. The STOXX Europe 600 Index (.STOXX) currently sits at around 460, within spitting distance of its 494.35 all-time high from January 2022. Since hitting its recent lows in late September, it has risen more than 22%, dwarfing the 14% increase in the S&P 500 Index (.SPX) of leading U.S. stocks.
This kind of outperformance is unusual – the last time it happened consistently was between 2005 and 2007. Since then, investors have gravitated towards the bigger, deeper and more technology-heavy U.S. market.
Luck played a part in the recent European surge. The spike in energy costs caused by Russia’s invasion of Ukraine did not lead to a much-feared recession, partly because the winter was mild and governments bought fuel from elsewhere. Natural gas prices have fallen more than 80% since their August peak, boosting economic growth and reducing companies’ costs.
China also helped. Beijing lifted draconian Covid lockdown measures in December. Since then, the Middle Kingdom’s economy has been on a tear. GDP grew at an annual rate of 4.5% in the first quarter of 2023, boosted by domestic consumption. That prompted investors to buy into European exporters. Shares in France’s LVMH (LVMH.PA), which derives 30% of its sales from Asian countries outside Japan, have risen more than 25% this year.
The makeup of European equity markets also played a large role. Nearly 40% of the region’s stock market consists of so-called cyclical stocks, such as banks and industrial firms, whose fortunes tend to rise and fall with the economy. That compares with just 22% in the United States, according to JPMorgan. The current environment of high inflation, elevated interest rates and slow growth favours these companies, by enabling them to charge more for their products and services. Shares in Italy’s UniCredit (CRDI.MI), a large lender, have risen by more than a third since January despite banking failures in the U.S. and Europe.
This supportive environment lured investors to Europe after years of indifference. What they found was a treasure trove of relative bargains. Even after the recent run, Europe’s shares trade on a multiple of 12.7 times next year’s expected earnings, according to IBES estimates, which is a 30% discount to U.S. valuations.
Now, though, the fair winds are about to change. For a start, economic clouds are gathering. To fight rampant inflation, the European Central Bank has raised interest rates from below zero to 3% in just eight months. They could reach 4% before the summer.
Sharp monetary tightening will slow growth to a trickle, dampening demand and curbing spending by households and companies. The ECB expects the euro zone economy to expand by just 1% in 2023, compared with 3.6% last year. For both 2024 and 2025, the central bank projects a modest 1.6% rise in GDP. Higher rates and banking stresses will also make it more difficult and expensive for companies to access capital. And the strength of the euro against the dollar will reduce the value of profits earned abroad, while making European goods more expensive. The single currency is trading around 10% higher against the greenback than last year’s average.
Those factors could tank profits. Analysts currently expect a 0.4% fall in European companies’ earnings per share (EPS) in 2023, according to Barclays. That looks too optimistic. In a recent note, Morgan Stanley’s Graham Secker estimates that the euro’s strength alone could lop 5% off EPS. On top of that, lower economic growth is likely to reduce demand and volumes, while falling inflation will put pressure on prices, bringing operating margins down. Under these conditions, EPS could drop by up to 10% this year, Secker calculates. As the bad news becomes evident, stocks could take a dive.
Some investors are already taking their business elsewhere. Europe-focused equity funds have suffered six consecutive weeks of outflows, according to Bank of America. Europe-focused actively-managed funds have seen total outflows of more than $18 billion in 2023 but that has been partially offset by $15.6 billion of inflows into passive funds that invest in the region.
Emerging markets’ equities are a viable alternative. They are cheaper than European stocks, trading at 12 times next year’s forecast earnings, using the MSCI Emerging Markets Index. And corporate fortunes in those countries are likely to be buoyed by China’s recovery, high commodity prices and a weak dollar.
Fund managers with a broad mandate could also consider U.S. investment-grade bonds. The yield on the S&P U.S. Aggregate Bond Index, which tracks dollar-denominated high-quality debt, is 4.58%. That’s lower than March’s 5.02% but still well above the 3.24% of a year ago. If the global economy takes a gentler downward path, investors will benefit from locking in these high yields.
And if the economic landing is harder and central banks cut rates, bonds may perform better than equities. Mark Haefele, chief investment officer at UBS Global Wealth Management, reckons IG bonds could this year offer a total return that’s 14.6 percentage points above the one on offer from holding the S&P 500.
European investors have had an unusually enjoyable, and profitable, ride. But it’s becoming increasingly clear that the best opportunities are now elsewhere.
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CONTEXT NEWS
The STOXX Europe 600 Index rose by 22% between Sept. 29 and May 2, compared with a 14% increase for the S&P 500 Index of leading U.S. stocks.
