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The Case for Revisiting Europe

Buffeted by the COVID-19 pandemic and then by the Russia-Ukraine War, Europe has continued to struggle economically, with its competitiveness taking a hit. Yet Europe’s resilience has shone through these crises and green shoots of recovery are already visible. We take stock of Europe’s macroeconomic and investment landscape in light of these encouraging developments.

Chief Economist
Portfolio Manager

We embraced a “positive eurozone” macro view in early 2021 amid an improving macro policy backdrop – essentially, the re-introduction of fiscal policy into the macro scene. This view played out nicely for a while only to be dramatically challenged by the Russia-Ukraine War and the subsequent hit to regional competitiveness.

In this piece we discuss the evolution of our views on the eurozone economy and argue that the deterioration in competitiveness is an easier challenge to solve than the prior lack of internal cohesion. We therefore retain a favorable bias despite ongoing challenges.

Prior to the COVID-19 pandemic, the eurozone’s biggest challenge was a lack of cohesion among member countries dealing with varying growth pathways but anchored to the same interest rate policy. This set up had posed macro instability risks from the very beginning of the euro project.

Early on, this took the form of what we call “the temporary death of country risk premium,” illustrated by the near complete convergence of borrowing costs between Italy and Germany from 1998 (Figure 1).

This incentivized a surge in debt issuance that initially fueled explosive growth in economies such as Greece and Spain but ultimately proved unsustainable as risk premia rose again in the aftermath of the Great Financial Crisis. Following the euro crisis in 2011, the bloc struggled with a different challenge: intense austerity in debt-burdened economies, which has resulted in a steadily widening growth differential across member countries.

It is astounding, but Greek real GDP is essentially the same today as it was back in 2000. Italy is not much better off either, with 6.0% cumulative growth over the same period (Figure 2).

Europe’s Competitiveness Gap

We saw the re-introduction of fiscal policy in the eurozone as an important development that aided the internal cohesion of the bloc. After a decade of nothing but austerity, the policy response to the pandemic finally included constructive elements including the Next Generation EU Fund.

This was the initial basis of our “positive on Europe” macro and investment view back in 2021. It worked well for a while, and then the Russia-Ukraine War broke out.

Not only were acutely negative scenarios suddenly on the table, but the old problem of cohesion was being replaced by a new problem of loss of competitiveness. For years, the trouble had been that Germany was seemingly “doomed to boom” while Greece and Italy seemed doomed to underperform.

We had long highlighted the varying trajectories of these countries’ GDP deflators as a visual illustration of this “competitiveness divide.” The higher the deflator, the higher the broad cost of producing goods and services in that economy and the worse its relative external competitiveness. The result is growth underperformance.

In an ideal world, that competitiveness gap would be favorably closed by less-competitive economies becoming more competitive. In practice, over the past year or so, the eurozone’s competitiveness gap has been narrowing in the wrong way: rather than Italy becoming more like Germany, Germany is becoming more similar to Italy (Figure 3).

Does This Spell the End of Our Positive View?

Not necessarily. To be sure, the hit on competitiveness is real, but the question is whether this will persist or not. In our view, much of the decline in competitiveness seen over the past year can be unwound over the medium term – the initial stages of that unwinding process may already be at hand.

While the Russia-Ukraine War has brought to the fore eurozone vulnerabilities that had grown unattended over the past two decades (i.e., energy security, defense, and food security), the crisis also forced a realization that these challenges can no longer be wished away and must be addressed head on with policy actions. These policy actions involve investment and that investment means more resilient growth.

Why do we believe that the competitiveness hit can be alleviated over time? For one, the eurozone has weathered through what presumably was the most acute period of energy crisis last winter, without the much-feared broad interruptions to economic activity.

When that was accomplished, skeptics pointed out that this one-time success may not be replicated, since it was facilitated by slowing Chinese demand and reorientation of supply from Asia to Europe. A year later, as another winter approaches, Chinese demand continues to remain sluggish and natural gas storage levels across the eurozone are far above typical levels for this time of year.

Europe’s Resilience Underappreciated

As of August, German natural gas storage stood over 93% of capacity. A year ago, that number was 81%, and in August of 2021, before the Russia-Ukraine War, it was a mere 55%. This piece is not a deep dive into European energy policy, but we would like to make the broad point that, generally speaking, the supply does exist at the global level (look no further than OPEC’s efforts to actually curtail supply).

While it is an inconvenience and an investment commitment to diversify either the geographical source or the compositional structure of energy supply, this effort is already underway, and will continue to make progress. As the initial shock fades and supply security improves, European energy costs should start to normalize. This is already evident in German producer price index data (Figure 4).

Figure 4: Starting to Heal the Hit to Germany’s Competitiveness

Much work undoubtedly remains to be done to heal the economic wounds triggered by the Russia-Ukraine War, yet we believe the healing process has already begun. And while risks to the outlook certainly remain – evidenced recently by the sharp decline in PMI indicators – the region’s resilience appears underappreciated.

Eurozone’s real GDP grew 3.4% last year, when many thought the energy shock would trigger a recession. Even this year, the 0.3% expansion during the second quarter has once again delayed the onset of any potential recession. Shouldn’t investors be looking closer at a region that continues to surprise favorably despite really tough odds?

European Equities and the Tech Problem

Indeed, seasoned investors would not have to look very long to find among Europe’s publicly traded equities an abundance of highly competitive multi-nationals with world-leading brands and management. In many cases these firms dominate their end markets both domestically and globally.

Without much effort, consumers and businesspeople from any region could rattle off names of Europe’s globally dominant food, pharmaceutical, biotechnology, automobile, luxury fashion, industrial and energy juggernauts. And yet, in 2023, there is something obviously absent among European listings, which can be summed up, albeit a bit too simplistically, in one word: Technology.

Among the world’s largest technology firms, shockingly few have their homes in Europe. Among the roughly 150 firms comprising the Bloomberg World Technology Index, only 9 are European, and together they make up only 5% of the index. There is only one European name among the top 10 by index weight, and only 5 among the top 50.

Note that this index does not include the e-commerce, streaming and social media giants of the US and China, all of which, if included, would make Europe even more poorly represented amongst the world’s largest publicly traded technology firms.

The near-total absence of technology leaders in European indices has led to two severe and very memorable periods of underperformance versus US equities during the pandemic and post-pandemic periods. In calendar year 2020, Europe underperformed the US by a whopping 24% in local currency total return terms. Thus far, in 2023, Europe has lagged by 8.5%. These two periods have something in common: the dominance of tech-led narratives.

In 2020, the pandemic kept workers at home and on their devices, corporates poured money into the technology necessary to facilitate remote work, and investors could not get enough tech into their portfolios. In 2023, the narrative has revolved around the AI revolution, which has generated almost unimaginable revenue growth revisions for a handful of leaders.

In both cases, broad US markets massively underperformed US technology, and Europe, having so little of what was “working,” massively underperformed the US on a regional basis (Figure 5).

The Case for European Equities

One need not parse the last three and a half years of market history to find convincing evidence of the resilience of European equity and its contribution to global portfolios, notwithstanding the dominance of technology for much of that period. Since the end of 2021, almost exactly when global equity markets (and the pandemic-induced technology surge) have peaked, European equities have outperformed US peers by >10% and global peers by 8.5%, in local currency total return terms.

Outperformance has been smaller in US dollar (USD) terms (about 5% and 3% respectively) but has been still positive for Europe. Looking forward, our tactical signal suites highlight that in terms of earnings and balance sheet quality, as well as valuations, Europe shines versus its global peers.

With respect to valuations, and in light of those performance statistics, it is worth remembering what most investors know but are always prone to forget – a world-beating company or sector can quickly become a terrible investment once the value of its assets and speed of its growth are widely appreciated.

This means, instead of fretting over a lack of technology leadership in Europe, investors should use periods of technology exuberance (such as 2020 and thus far in 2023) to shift their attention to the many sectors in which world-beating European companies are dramatically overrepresented and can easily drive Europe to global outperformance.

In Conclusion

Europe’s policy response to the pandemic was constructive, but then the Russia-Ukraine War broke, pouring cold water on the positive views on Europe’s revival. But the eurozone’s resilience, including its weathering of the energy crisis last winter, continues to be underappreciated. Eurozone’s real GDP grew 3.4% last year, defying predictions of a recession, and the 0.3% expansion during the second quarter of 2023 has pushed forward the onset of any potential recession.

Looking at equities, the technology led outperformance that has continued to dominate the investment landscape has masked the fact that Europe continues to dominate multiple sectors that deserve our attention. All things considered, investors should do well to look closer at a region that continues to surprise favorably despite the tough odds that it has faced recently.

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