No, while the recent outperformance and positivity surrounding Eurozone equities was justified by shifts in the macroeconomic landscape, we do not have confidence that outperformance will continue, given the challenges still facing the region. Therefore, we suggest investors keep Eurozone equity allocations in line with policy weights.
Since their recent relative low point at the end of August, Eurozone equities have returned 24.1% in USD terms, in comparison to just 3.3% for global equities, according to MSCI data at the end of February. In that time, the outlook for European growth has improved for several reasons. Firstly, and most significantly, the price of natural gas moderated substantially. The European gas benchmark price declined from a peak of €311 per megawatt hour (MWh) to less than €50 per MWh, a price level not seen since 2021. Secondly, the squeeze on consumer purchasing power was ameliorated by the roll out of fiscal support programmes by many governments in the region. Finally, news that China was loosening its zero-COVID policies provided an additional tailwind, due to the export orientation of the Eurozone economy.
These developments saw 2022 GDP growth in the Eurozone come in at 3.5%, versus consensus expectations that reached as low as 2.6%. Similarly, 2023 consensus growth is currently running at 0.4%, up from a low of -0.1%. This necessary revision to growth projections, coming at a time of bearish investor positioning in the region, saw flows into Eurozone equities pick up significantly in recent months. The composition of the Eurozone equity market, namely its tilt towards value sectors, has also aided relative performance. The MSCI EMU Index was underweight some of the worst-performing sectors since August, including real estate, communication services, and IT, while being overweight the three best-performing sectors – financials, materials, and industrials.
Despite these various improvements to the outlook, we do not have confidence that this trend will continue. Starting with valuations, Eurozone equities still look optically cheap, having a cyclically adjusted price-to–cash earnings (CAPCE) that is just 0.67 that of broader developed markets (DM) equities. However, not only is that up from a low of 0.57 in early 2022, it is now above the median level of relative CAPCE between the two blocs. This relative valuation also appears approximately ‘fair’, given the lower profitability of Eurozone equities and accounting for sectoral differences.
Surprises in Eurozone economic data have been outstripping those of global peers for nearly four months, and by near record levels earlier this year, based on data from Citi. We think the macro headwinds facing the region make continued outperformance less likely going forward. Firstly, trends in credit metrics are consistent with sharply slowing growth. Credit standards have tightened to levels last seen during the sovereign debt crisis, while demand for credit for fixed investment and mortgages has declined sharply. Consistent with this, net lending across corporates, mortgage, and consumer loans has turned negative. As the pick-up in inflation in the Eurozone lagged that of the United States, monetary tightening commenced later. Meaning that on a relative basis, the Eurozone may not yet have experienced the same degree of monetary drag as the United States. In line with the lag in inflationary dynamics, the European Central Bank may also maintain a hawkish posture for longer than some peers.
If a recession occurs, as we expect, the greater cyclicality of the Eurozone economy and EMU equity earnings should see them more exposed to this demand slowdown. During past recessions, the United States has tended to be defensive relative to other DM equities. Therefore, the large weighting of the United States in global and DM indexes suggests these broad indexes may outperform Eurozone equities in the event of a recession.
Certainly, there is the possibility that Eurozone outperformance could persist. For instance, if a recession is sufficiently mild and/or short-lived (or altogether avoided), then value may continue to outperform, providing a tailwind for Eurozone equities. Similarly, an environment in which global growth remains solid, while US inflation returns to target, could see the US dollar weaken and provide a boost for non-US equities. However, we believe it is hard to have conviction in such a view, given the headwinds facing the region and the elevated level of global macro uncertainty, including the risk of military escalation in Ukraine. As such, we recommend that Eurozone equity allocations are kept at policy weights.