In the short term, Europe’s economy stands to play catch-up to the rest of the world; longer-term, fiscal rules could present a turning point for the region’s position in investor portfolios.
Joe Seydl, Senior Markets Economist
Pieter Clerger, Junior Markets Economist
The slow start to vaccinations and re-opening in Europe has understandably cast a shadow on the outlook for the region’s economic recovery. However, Europe’s markets have fared much better than its economy over the past six months. Indeed, despite the U.S. economic recovery significantly outpacing Europe’s since November, Europe’s stock market has actually outperformed the U.S.’s over the same time period.
What explains this disconnect?
For one, Europe’s markets are highly geared to the global industrial cycle. This is illustrated in the below chart, which plots equity market flows into and out of the global industrials sector against Europe’s relative stock market performance compared to the U.S.’s. You can see that for the most part over the last 10 years Europe’s markets have underperformed, but when the global industrial cycle heats up, Europe’s markets shine.
European markets highly geared to global industrial cycle
European manufacturing booming while services continue to struggle
European markets much more geared towards cyclical sectors
Further, with the vaccine rollout now ramping up throughout mainland Europe, and talk of reducing restrictions to allow for summer travel, investors seem to be looking forward to the region’s return to normal. As a result of the crisis and unprecedented fiscal stimulus efforts, consumers have built up massive savings, even reaching close to 10% of GDP in some countries. As economies reopen, the release of pent-up demand could go a long way. We expect services to play catch-up as lockdowns end, providing a boost to Europe’s mobility-oriented economy. This also bodes well for cyclical areas of the Europe’s market.
Where do we go from here?
A key question for investors at this juncture, however, is whether Europe deserves more than just a tactical “on-and-off” allocation related to the global industrial cycle. The cycle will eventually slow, and at this point will Europe then revert back to its structural position of equity market underperformance?
We are increasingly of the view that Europe deserves a re-think in long-term investment portfolios. While we are not there yet in terms of overweighting the region in our equity portfolios, we are of the view that Europe no longer deserves a structural underweighting. A significant part of the reason why pertains to Europe’s evolving stance on fiscal policy.
European leaders are proving themselves determined not to repeat the mistakes of austerity made in the 2010s. Coming out of the 2008 Global Financial Crisis (GFC), austerity was preached as the prudent approach to avoid sovereign bankruptcies and stimulate a healthy recovery. The programs of higher taxes and government spending cuts, at a time of already depressed domestic demand, effectively resulted in a double-dip recession and societal rift.
Fast forward to today, and the austerity conversation appears very different. There is now a clear intention among policymakers to support the economy until the pandemic weakness is fully in the rear-view mirror. In the U.K., for example, Chancellor Sunak, in his budget speech, stated that he would do “whatever it takes,” and with that he introduced a 2021 budget that pencils in the largest peace time deficit in U.K. history (17% of GDP). The budget includes a laundry list of initiatives to support businesses, individuals, & public investment. Meanwhile, the EU Commission recently announced the likely extension of the General Escape Clause into 2022, relieving fears of a “fiscal cliff” hitting just as the pandemic ends.
The COVID crisis may be a turning point in the structural reform of EU fiscal rules. At the moment, a majority of EU countries are projected to be in violation of the main tenants of current rules (i.e., a budget deficit that does not exceed 3% of GDP and debt not exceeding 60% of GDP). For some particularly fiscally weak countries, such as Italy and Spain, a sharp return to current rules in 2023 would require significant budget cuts that would likely derail the recovery at that point in time.
During this crisis, clamor has grown for changes to current fiscal rules to permit more accommodation on a permanent basis going forward. Possible structural changes to EU fiscal rules may include: (1) taking more consideration of a country’s economic standing (e.g. not requiring spending cuts when deficits rise due to a fall in GDP during an economic contraction) and (2) excluding pro long term growth spending (e.g. on infrastructure) in each country’s deficit calculations. European Commissioner for the Economy Paolo Gentiloni has signaled that discussions on rule changes would not begin until the recovery is on a solid foothold, but important political developments lay on the horizon.
Germany, as the EU’s largest economy, will hold significant sway over these discussions, making this September’s federal elections, where Angela Merkel’s replacement will be chosen, critical to follow. CDU head Armin Laschet is the current favorite to take over the chancellorship and he has positioned himself as the “continuation candidate” of Merkel’s leadership (and its traditionally fiscally hawkish stance). That being said, the strength of the Green party in recent polling and state-level elections could indicate that even in Germany there is appetite for more relaxed fiscal policies.
Finally, NextGenerationEU funds, which must be used for public investment, have the potential to boost the long-run potential GDP growth rate. Although details on projects are still being finalized, for some countries (including Italy & Spain) funds will double current annual public investment. Funds may begin to be distributed as early as the second half of this year; however, a majority of the impact will be felt next year and beyond. It should be noted that success of the funds depends on the willingness and speed of governments to implement required reforms and spend the funds.
NextGenerationEU fund to have significant impact on public investment in periphery
So what does this all mean for markets?
In the short term, we believe Europe’s economy stands to play catch-up to the rest of the world, and cyclical areas of its market look poised to outperform. When it comes to the Euro, investors seem to have priced in the worst, and anticipate the currency vs. the U.S. dollar to recover and stabilize throughout the second half of the year (we see EURUSD around $1.18-1.22 by Q1 2022).
Over the longer-term, if we are indeed on the cusp of a permanent fiscal rethink in Europe, it could mean that longer-term interest rates start to rise on a sustained basis, which would be supportive for Europe’s banking sector. Flat yield curves in Europe are reflective of the ECB carrying the entire burden when it comes to supporting domestic demand. More supportive fiscal policies would take some of the weight off the ECB, allowing it to taper its bond purchases, with the end result being a steeper European yield curve. This is notably what has happened in the U.S. since the start of the year, as the greater than expected fiscal thrust implemented by the Biden administration allowed the Fed to take a more relaxed stance with regard to rising longer-term yields. In the U.S. market, the financials sector is the second best performing sector year-to-date (behind energy).
Sufficient fiscal support allowed the Fed to take a relaxed approach to rising yields
The ECB has had to most of the heavy lifting
Sufficient fiscal support has lowered the political risk premium
To be sure, one headwind for Europe is that domestic corporations remain much less shareholder friendly than their counterparts in the U.S. (i.e., fewer buybacks and less cost cutting), and this is unlikely to change anytime soon. This factor has been a significant contributor to returns, and helps explain why return-on-equity measures in the U.S. have been roughly 50% higher than in Europe over the last 10 years.
That being said, the stability of ROE measures in the U.S. are beginning to be questioned, not from a fundamental perspective but rather from a political economy perspective. The 2017 U.S. corporate tax cuts were a major tailwind for corporations that resulted in higher earnings and share buy backs. President Biden’s physical infrastructure plan calls for raising corporate tax rates in order to finance the proposal. The potential hit to earnings as a result of increased taxes could end up being a drag on U.S. equity returns that European markets do not face.
International public equity investors have understandably shied away from the European region for the better part of the last decade. However, the industrial driven global recovery coupled with a push in Europe to keep fiscal policy accommodative as long as necessary makes the region worth reconsidering. Naturally, there are risks to our view. The unpredictability of COVID, including potential virus mutations, remains a top risk. Upcoming political developments that may result in insufficient fiscal support going forward is another key risk, and as mentioned, this September’s German federal elections will be a pivotal event for Europe’s economy more broadly. Yet, assuming the current trajectory is maintained, we believe the region is poised for continued solid performance in the near term, and a neutral long-term portfolio allocation.