European equity markets have been a victim of a confluence of external and internal headwinds – global trade tensions, the slowdown in the Chinese economy, structural changes in the auto industry and ongoing Brexit related uncertainty.
Since 2013, European equity markets have underperformed US equity markets with the outperformance gap extending to its widest level since 2000. Value stocks account for a higher weight in Europe compared to the US which has a higher tilt to growth stocks.
Since the great financial crisis, growth stocks have surpassed value stocks by a strong margin which also accounts for Europe’s lack of performance. The European single currency is now trading at its weakest level versus the US dollar since May 2017; however European exporters have not benefited from any competitive advantage.
In the first ten months of 2019 Eurozone domiciled equity linked Exchange Traded Funds (ETFs) have witnessed outflows worth US$8.1bn, underpinning the severity of pessimism towards European equities. Owing to the cautious outlook, defensive sectors of the European economy have become overcrowded compared to cyclical sectors. Europe can only stage a turnaround if we see a combination of improved global trade negotiations, recovery of value stocks coupled with meaningful fiscal stimulus.
European economic data continues to deteriorate
The deterioration of European economic data has shown no signs of abating. The flash Eurozone manufacturing purchasing managers index (PMI) fell to its worst level in nearly seven years with the reading at 45.6 in September down from 47 in August.
Weakness was also observed in the services sector where flash eurozone services PMI fell to an eight-month low. This is a worrying sign, because downturns are often spotted first in the manufacturing sector before transmitting to the services sector as manufacturing tends to respond more quickly to changing demand conditions.
A further decline in the employment component of the composite PMI, which fell to levels in line with stagnating employment and modestly rising unemployment was another sign of the weakness spreading to domestic demand.
Germany has been hit hardest by China slowdown
Europe’s largest economy, Germany has been hit the hardest by trade and Chinese slowdown related headwinds, as exports make up 47% of its GDP. This became apparent from the recent decline in the manufacturing PMI level to 41.4 in September from 43.5, marking its worst reading in more than a decade.
Germany accounts for a large proportion of auto production and the introduction of new European Union emission tests also contributed to a loss in momentum to the sector. The fact that Germany has a continent-wide supply chain that accounts for 29% of Eurozone GDP raises the probability of Germany’s slide into recession negatively impacting other Western European economies.
To make matters worse, the World Trade Organisation (WTO) has authorised the US to impose tariffs on nearly US$7.5bn of European aviation and luxury goods due to illegal state aid provided to European aircraft maker Airbus SE. If the Trump administration presses ahead with tariffs, it is likely to trigger retaliatory measures from the EU and further sour trade tensions between the two nations.
On 20 September, the German government announced a €54 billion climate spending package aimed at reaching the 2030 emissions reduction target. This is expected to be financed from existing surpluses in the energy and climate fund implying a minor net fiscal net boost of less than 1.6% of GDP.
What about the European Central Bank?
On September 12, the European Central Bank (ECB) unleashed a substantial easing package that included – a 10 basis point (bp) reduction in the deposit rate; restart of net purchases under its asset purchase programme (APP) at a monthly pace of €20 billion; more generous targeted longer-term refinancing operations (TLTRO III) and launched a two-tiered deposit rate to mitigate the cost of negative interest rates for banks.
However monetary policy alone cannot fix Europe’s problems. Europe’s chief problem is not one of lack of access to capital for companies or high cost of capital, but rather one of deficient external and internal demand. Due to external shocks such as trade wars, Brexit and China’s slowdown, global demand conditions remain weak. Owing to this, fiscal policy in Europe which remains tighter than it needs to be, must do more in order to support internal demand conditions.
Former ECB President Mario Draghi also echoed these thoughts at his last ECB press conference, where he emphasised that it was time for fiscal policy to pick up the baton from monetary easing as growth and inflation targets are unlikely to be achieved without the role of fiscal policy. The current multi annual financial framework covers the years 2014-2020 and has an envelope of €1,087 billion or 1% of EU GDP.
European Commission plans new budget
Preparations for the European Union’s (EU) new 2021-2027 budget are well under way. A new Multiannual Financial Framework (MFF) for the period of 2021-2027 was proposed by the European Commission (EC), targeting a budget of roughly €1.3trn across a broad range of different policy priorities of the European Union. The newly proposed MFF aims at strengthening the social dimension of the Union. For next year, the EC will continue to implement the programmes approved under the MFF 2014-2020, while it promotes the adoption of the proposed MFF 2021-2027.
European valuations have historically been trading at a discount to the US. According to cyclically adjusted Price to Earnings ratio (CAPE) European equities (CAPE at 18.35x) are trading at a 10.6% discount compared to US equities (CAPE at 20.54x).
Historically European companies have also paid out a greater share of their earnings to shareholders in dividends compared to the US. Higher dividend yields in Europe at 3.71% compared to US equities at 1.9% enhance the case for investing in European equities especially at a time when nearly US$14trillion of global debt is negative yielding.
The cautious outlook held by investors has resulted in overcrowding in certain segments of the European markets, namely – growth, large cap and internationally exposed stocks. The price to earnings (p/e) ratio of value compared to growth stocks are trading at its lowest level since 2005.
Despite offering a 6% premium on the dividend yield, European small cap stocks trade at a 5% p/e discount to large caps compared to the long run average. While internationally exposed European stocks have outperformed their domestic peers by 44% since 2007.
Our thanks to WisdomTree for their help with this article. www.wisdomtree.eu