Macro: Sandcastle economics
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Q2 Outlook: The great divergence
Peter Garnry
Chief Investment Strategist
Chief Investment Strategist
Summary: European equities are global laggards, with weak earnings and low valuations keeping prices well below those of their US counterparts. As we prepare to exit the era of convergence and increasing globalisation, Europe looks set to fall further behind. The question is, what can policymakers do?
In this Q2 Outlook we have chosen to focus on Europe and the outlook for the region’s equities . The depressing reality is that European companies have had negative real growth in operating earnings as the region lacks a strong technology sector that capitalises on the digital age.
Europe's earnings depression
The period after the financial crisis in 2008 was unique in many ways. Monetary policies were experimental to an unprecedented degree, leading to negative yields on many assets around the world. Global equities have delivered phenomenal returns despite lacklustre economic growth, and this was driven largely by US equities, and US technology companies in particular, monetising our digital world.
The post-2008 crisis has also delivered several European political crises with Brexit being the latest one. The US and China have increasingly diverged in terms of worldview, leading to a trade war that has impacted economic activity significantly. On top of this, the period has seen inequality rise with populism following in its footsteps. Everywhere we look, the world is diverging more than converging (which was the main theme from 1982 to 2008).
The period after the financial crisis in 2008 was unique in many ways. Monetary policies were experimental to an unprecedented degree, leading to negative yields on many assets around the world. Global equities have delivered phenomenal returns despite lacklustre economic growth, and this was driven largely by US equities, and US technology companies in particular, monetising our digital world.
The post-2008 crisis has also delivered several European political crises with Brexit being the latest one. The US and China have increasingly diverged in terms of worldview, leading to a trade war that has impacted economic activity significantly. On top of this, the period has seen inequality rise with populism following in its footsteps. Everywhere we look, the world is diverging more than converging (which was the main theme from 1982 to 2008).
For global equity markets, this broad divergence can be seen in the major earnings divergence between US and European companies. Operating income (EBITDA) is up 50% since January 2009 for US companies, whereas European companies have seen 0% growth. European earnings are down 13% in real terms, translating into what we would call an earnings depression for Europe.
The difference in earnings power has also made its mark on valuation metrics . US equities are valued 43% higher than European equities measured on 12-month trailing EV/EBITDA. The difference in earnings power and valuation has been driven by multiple factors, but the most important is Europe’s lack of a strong technology sector. The US, meanwhile, has won the battle for domination of the information age, and especially its monetisation.
Avoid Europe's cyclical countries
Adding to Europe’s difficulties is its big bet on globalisation through a highly-tuned export machine, with Germany leading the pack. Europe and especially Germany have benefitted the most from the existing world order of increasing global trade under the US military umbrella (which in turn reduces the need for military expenditures).
The difference in earnings power has also made its mark on valuation metrics . US equities are valued 43% higher than European equities measured on 12-month trailing EV/EBITDA. The difference in earnings power and valuation has been driven by multiple factors, but the most important is Europe’s lack of a strong technology sector. The US, meanwhile, has won the battle for domination of the information age, and especially its monetisation.
Avoid Europe's cyclical countries
Adding to Europe’s difficulties is its big bet on globalisation through a highly-tuned export machine, with Germany leading the pack. Europe and especially Germany have benefitted the most from the existing world order of increasing global trade under the US military umbrella (which in turn reduces the need for military expenditures).
With the US-China trade conflict, it seems likely that the world is entering a new world order with diverging views and more nationalism guiding trade policies. In this world, Europe and Germany are big losers. One option for Europe is to reduce exposure to the US and
increasing it to China, but that strategy comes with great political risk.
Europe’s sensitivity to global trade has been felt by citizens for more than a year now. The Organisation for Economic Co-operation and Development’s leading indicators on the euro area have been declining since December 2017 and have been below trend (meaning below 100) since August 2018, mimicking leading indicators on the global economy. As a result, European equities are still 6.6% below their recent peak in January 2018.
Contracting economies with below-trend activity have historically delivered negative equity returns. Consequently, we remain defensive on equities until there is evidence of a turning point.
Within Europe, this macro environment is typically bad for Europe’s cyclical equity markets such as Germany, Italy, the Netherlands, Norway and France. The equity markets that usually do relatively well in a poor economic environment are Denmark, Spain, Sweden, Switzerland and the UK.
increasing it to China, but that strategy comes with great political risk.
Europe’s sensitivity to global trade has been felt by citizens for more than a year now. The Organisation for Economic Co-operation and Development’s leading indicators on the euro area have been declining since December 2017 and have been below trend (meaning below 100) since August 2018, mimicking leading indicators on the global economy. As a result, European equities are still 6.6% below their recent peak in January 2018.
Contracting economies with below-trend activity have historically delivered negative equity returns. Consequently, we remain defensive on equities until there is evidence of a turning point.
Within Europe, this macro environment is typically bad for Europe’s cyclical equity markets such as Germany, Italy, the Netherlands, Norway and France. The equity markets that usually do relatively well in a poor economic environment are Denmark, Spain, Sweden, Switzerland and the UK.
On a positive note, South Korea’s leading indicators turned higher in January, indicating a potential green shoot which will, if it continues, lift Europe’s economic activity and potentially also its equity markets. The reason we are closely watching South Korea is that its economy and equity market have historically turned before those of its global counterparts.
A broken banking system and the German syndrome
One of Europe’s biggest problems remains the banking sector. The total return on Europe’s banking sector is zero since January 2003; in real terms, it’s -28.5% over a 15-year period. This is an ugly parallel to Japan’s zombie banks after its meltdown in the 1990s.
A broken banking system and the German syndrome
One of Europe’s biggest problems remains the banking sector. The total return on Europe’s banking sector is zero since January 2003; in real terms, it’s -28.5% over a 15-year period. This is an ugly parallel to Japan’s zombie banks after its meltdown in the 1990s.
Europe’s policymakers, including the European Central Bank, were too slow to recognise the realities of the post-crisis economic landscape. The Federal Reserve quickly introduced quantitative easing, and sharply increasing reserves in the system that could then be parked at the Fed at 50 basis points helped recapitalise the US financial system. In Europe, however, QE came much later, and probably too late to really resolve the issue: Europe’s banks are still undercapitalised and poor profitability is constraining credit transmission.
Europe has also agreed to implement costly banking regulations, driving up costs on an already weak sector. It has been 10 years since Lehman Brothers’ bankruptcy and Europe’s banking sector has still not healed; this will continue to be an anchor constraining growth and equity returns.
The latest political attempt in Germany to merge Deutsche Bank and Commerzbank is a clear signal as to the current political system’s ability to understand the nature of the problem. Banks are already too big and complex, jeopardising the overall system, and Berlin wants to increase banking sector concentration despite popular outcry. A sensible approach would be to increase competition instead of limiting it.
Europe has also agreed to implement costly banking regulations, driving up costs on an already weak sector. It has been 10 years since Lehman Brothers’ bankruptcy and Europe’s banking sector has still not healed; this will continue to be an anchor constraining growth and equity returns.
The latest political attempt in Germany to merge Deutsche Bank and Commerzbank is a clear signal as to the current political system’s ability to understand the nature of the problem. Banks are already too big and complex, jeopardising the overall system, and Berlin wants to increase banking sector concentration despite popular outcry. A sensible approach would be to increase competition instead of limiting it.
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