- European stocks are oversold.
- Europe is a model of fiscal discipline.
- Europe is showing impressive resolve.
- A warm winter.
- European equities are cheap.
Many economic indicators point to a global slowdown. Unprecedented tailwinds in the form of free money and fiscal profligacy have turned into major headwinds. The Federal Reserve’s recent Quantitative Tightening is having an effect that mirrors and reverses Quantitative Easing’s wealth effect. Since QE ended, asset prices across the board are down dramatically. Even more than higher interest rates, the contraction of money supply has caused last year’s asset deflation.
Michael Cembalest of J.P. Morgan Asset Management writes in his latest letter that the developed economies are exiting “the largest combined monetary and fiscal experiment in history” and that “a major growth slowdown is coming to the U.S. and Europe”. We agree, but in our view Europe will be in better shape than North America.
Lower equity prices and higher cost of capital, combined with the end of unprecedented fiscal stimuli in the world all point to a slowdown of economic activity, if not a recession. However, a lot of this has been anticipated by the markets. Some markets, especially in Europe, have overreacted. It is time for investors to separate the wheat from the chaff. Not every company is equally vulnerable to a downturn.
European Relative Fiscal Discipline
This may come as a surprise but Europe has been a model of fiscal discipline, at least compared to the U.S. and Japan. The Euro-area’s fiscal discipline rules kept its members from going too far, even during the COVID lockdowns.
As of 2021, the combined gross debts of euro-area governments stood at “only” 95% of gross domestic product. This is up from 86% in 2010 and well above the agreed target of 60%*. However, the increase in Europe’s public debt looks puny compared to our recent “drunken-sailor”-like deficit spending. In the United States, public debt has shot up to 137%** of GDP, substantially surpassing Europe’s despite the fact that governmental revenues have gone up 40% since 2017!***The biggest debtor in the developed world remains Japan with a 225% ratio.
Abundance of cheap capital is a curse. It inevitably leads to excesses with negative long-term side effects. Japan is a case in point. Its economy is still trying to recover from the bursting of the late-1980’s speculative bubble which left banks with unmanageable loan defaults.
Another example is the Japanese chip industry, which also became the victim of monetary excesses. In his book on chip wars****, Chris Miller describes how cheap and abundant capital led to over-investment in Japanese semiconductor production. An inevitable downturn in global demand followed and crushed factories’ capacity utilization, productivity and profits. Korean and Taiwanese competitors have dominated the business ever since.
Closer to home, the Fed’s policy of improbably cheap money has encouraged politicians to go on a spending spree the like of which has not been seen since World War II. With the cost of debt so low, borrowing became irresistible. Deficits ballooned and debt has reached tens of trillions of dollars.
Today, the Fed’s aggressive hiking of interest rates is finally spooking some lawmakers. Even before the cost of borrowing money shot up, servicing the national debt already accounted for 15% of federal spending. Rolling over the existing debt alone will be very painful.
Like it or not, fiscal discipline is coming to America, be it through lower spending or higher taxes. We have no choice. Europe, on its part, continues to muddle through with already high tax burdens and reasonably high public deficits. Unlike the U.S., Europe is not in for a fiscal shock.
A Warm Winter in Europe, After All
Europe is showing impressive resolve and efficiency in its reaction to the Russian invasion of Ukraine. Quick action has prevented an immediate energy crisis. Natural gas from Norway, the Netherlands, the U.S. and Qatar are replacing Russian supplies. Floating LNG terminals are being built at record pace. 20 coal-fired plants have been reactivated in Germany. Enormous wind farms are being erected in the North Sea. France is revamping its nuclear facilities. Helped by mild temperatures, it now seems as if Europe is getting through the winter without much disruption. Already gas prices are back to “pre-war” levels on the Old Continent.
A More Assertive Europe
Last summer’s alarming headlines are making way to cautious optimism. The European economy is holding up. The German Chancellor even predicts that his country will avoid a recession in 2023. Investors are returning to the bourses.
The past year was not a good year for world peace. Nor was it a good year for dictators. Putin miscalculated and is now bogged down in a war of attrition. Xi Jinping was forced to make an embarrassing U-turn after years of extreme authoritarian Zero-COVID policies. The Ayatollahs’ regime in Iran is rotten to the core and faces serious social unrest. Turkey’s Erdogan is battling hyperinflation.
All in all, the European democracies have shown more resilience than they are given credit for. Putin’s humiliation has stiffened Western democracies’ backbones. Europe is reasserting itself. Europeans themselves may be the most surprised by this outcome of the war in Ukraine. Notwithstanding the usual vilification of the conservative governments of the former communist countries of Eastern Europe and the name calling between president Macron and Prime Minister Meloni, Europeans have shown remarkable unity. They have rallied around the common enemy. NATO, an entity that lost its raison-d’être after the collapse of the Soviet Union, has similarly been revived by the new threat coming from the east.
European Equities Are Cheap
Starting from the time of the first QE in early 2009, U.S. equities have traded at a premium to the rest of the world. Ben Bernanke’s “wealth effect” did not spill over to overseas assets. Every subsequent QE, up to and including the “mother of all monetary stimuli” caused by the pandemic response in 2020, has reinforced this price discrepancy between American equities and the rest of the world.
Investors like to use recent trends to project the future. But the premium valuation of U.S. equities seems long-lasting only if one looks back a decade or so. The chart above shows that overseas markets used to trade in line with the S&P before the Fed’s massive and repetitive interventions triggered the valuation gap of recent years.
European central banks ended up copying the Federal Reserve’s stimulative policies, but with a time lag and less conviction. The ECB only started QE in March of 2015, a full six years after Bernanke’s first move. Most of the speculative money was by then already chasing tech companies in North America. Even after last year’s global correction in stock prices, the S&P average PER was still at 17.5 compared to EMU countries’ average of only 11.9. The U.K. market trades at less than 10 times earnings. Japan, which used to trade at more than 60 times earnings in the late 1980’s, ended the year at 12.5 times projected earnings.*****
There seem to be good reasons for these valuation differentials. American technological superiority looms large among them. But, as this technology bubble bursts, the world may soon realize that companies headquartered outside of North America are not necessarily worth less, especially if they are truly global players.
Nor does a good company necessarily become bad because of a slowdown of the economy. On the contrary, the intrinsic value of a great business may become more obvious in tougher times. An initial selloff due to a temporary industry slowdown sometimes creates unique buying opportunities.
Looking ahead at the new year, Europe seems better positioned than the U.S. from a macro-economic point of view. Cycles tend to be more extreme in the New World. At the same time, European stocks are cheap, already having priced in a major economic downturn that may not materialize. Because European stock markets have been less affected by FAANG-type excess and speculation on unicorns, the risk of an upside surprise may be much higher than that of further selloffs on the Old Continent.
***The latest Congressional Budget Office report released earlier this month calculated that the federal government collected $4.9 trillion of federal revenue last year. This was up almost $1.5 trillion since 2017, the year before the tax cuts became law.
*****I.B.E.S. 12 month forward consensus by Refinitiv as of December 2022