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Are we seeing a European renaissance?

With investor confidence improving among European markets, we take a look at the trends and whether new optimisms will continue.

Published on 01 Mar 20234 minute read

Written by Daniel Casali

Continental European equities have long been the also-ran of global stock markets. However, encouraging economic and corporate earnings data, along with improving investor sentiment, has seen them break out of their trading range and outpace other developed markets since the start of the year. Can they sustain this momentum?

The immediate catalyst for stronger performance has been falling energy costs –particularly natural gas and electricity prices. A mild winter has allowed the region to retain high levels of natural gas storage, which has pushed prices lower. For the time being, the prospect of an energy crunch – and the risk that European manufacturing would seize up – has diminished.

As consumers and businesses see lower energy bills, it is starting to trickle down into improving confidence. These indicators have started to pick up from very low levels. The German IFO Index, for example, saw a notable improvement in February1. European Purchasing Managers Index data, which gives an early read on European growth, came in ahead of expectations in February, with the services sector particularly strong.

Behind the scenes, China’s reopening is providing another catalyst for the region’s economic growth. The country had already been loosening monetary policy even before it relaxed its zero-Covid rules. European Union (EU) exports are highly correlated with monetary stimulus within China. This should provide ongoing support for European companies.

European firms are already showing strength. European corporate earnings are picking up and their resilience has already surprised investors. Most businesses appear to have shaken off any concerns over high energy prices and the impact it could have on their profits. In general, companies have been able to raise prices more than input costs.

Headwinds for European markets: economic risks

There are headwinds for Europe. There has undoubtedly been a trade shock. The bill for imported energy shot up in 2022. However, this has now come down as the euro has appreciated and energy costs have fallen. It remains a headwind for the region, but it is moving in the right direction.

Further interest rate rises also remain a risk. As has been seen elsewhere, there has been a very sharp increase in interest rates from the European Central Bank (ECB). There are understandable fears that this could lead to a significant shock for economic growth. However, if inflation starts to ease back, the ECB will not be under the same pressure to tighten policy.

Not all the good news is in the price

European equities, excluding the UK, have performed well since the start of the year and there is a risk that much of the recovery is now in the price of shares. However, while the valuation of European shares is around its long-term average, there is scope for this to rise if economic data continues to improve.

We also look at measures of financial stress, such as the sovereign Credit Default Swaps (CDS) spread. There has been a small pickup in these CDS spreads, but there is no individual country under major risk of default. The situation is the same when looking at European banking CDS spreads. We would hope to see the CDS spread narrow as recovery takes hold.

Since the Global Financial Crisis, European equities have lagged US equities. This has largely been driven by the higher profits delivered by some of the major US companies. Today, we see European profits starting to outpace those of the US.

How do we reconcile the risks and rewards presented by European stock markets?

We think it makes sense to be relatively defensive when investing in Europe, focusing on areas such as utilities, staples and healthcare.

Providing confidence continues to recover, there could be further upside for European equities. Lower energy prices and stronger demand from China for European exports are lifting consumer and business optimism in the region. The economic data is now beating expectations at its fastest pace for two years. Analysts have tentatively begun to revise up company earnings expectations. Yet European equities, excluding the UK, remain at a discount to the rest of developed markets, and there are opportunities as the continent stages a renaissance.

Source:

1 Refinitiv / Evelyn Partners

Important information

By necessity, this briefing can only provide a short overview and it is essential to seek professional advice before applying the contents of this article. This briefing does not constitute advice nor a recommendation relating to the acquisition or disposal of investments. No responsibility can be taken for any loss arising from action taken or refrained from on the basis of this publication. Details correct at time of writing.

The value of an investment may go down as well as up and you may get back less than you originally invested.

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