Can European equities continue to ignore the bad news?

European equity valuations offer investors a conundrum

The lower economic growth in Europe has also impacted earnings growth with 12-month trailing EBITDA peaking in Q3 2022 and declining ever since including in Q2 2023. This development combined with excitement over AI technology, which benefits US technology stocks, have pushed European equities to their biggest valuation discount to US equities since January 2006. Investors are pricing European equities at a 35% discount relative to expectations over the next 12 months. In other words, US equities are priced for perfection against Europe and thus the contrarian investor would naturally tend to overweight Europe vs US despite the growth issues in Europe.

While investors are offered value in Europe it comes with risks. The continent is fast approaching its second anniversary of the war in Ukraine and Germany’s structural growth issues could hold back the continent unless Berlin wakes up to the new geopolitical reality of the fragmentation game. The energy crisis as function of the war in Ukraine and cutting energy trade with Russia, has not been solved and could come back and haunt Europe for a couple more years. Europe’s lack of fast-growing technology companies is another risk (the risk of low earnings growth in an age of digitalization).

Will Germany finally deal with its “sick man of Europe” issues?

Germany was often by the foreign press labelled the “sick man of Europe” during the 1990s and up until 2005 as structurally higher unemployment rate and low growth were part of the post-unification years. The expression has recently come back to live as the German economy has recorded three straight quarters of negative or flat GDP growth q/q with its industry complaining about bad industrial and energy policies.

China’s integration into the world economy through its adoption into the WTO in 2001 was a game changer for Germany. China’s growth in the subsequent years was high and its share of global trade skyrocketed as companies in the US and Europe were rushing to “outsource” its manufacturing to China as cheap labour and formidable logistics infrastructure made it a perfect platform for becoming the “world’s factory”. In building the “world’s factory” China needed a lot of advanced machines and knowledge which Germany’s industry provided jumping on the Chinese growth journey.

Angela Merkel, the Chancellor of Germany during 2005-2021, had for years an impeccable reputation, but her years as Chancellor overlapped with the rise of China providing tailwinds for the German economy. One could be cynical saying that Merkel’s apparent success was due to China’s policies. One thing was not luck, and that was Merkel’s deliberate integration with the Russian economy in the form of cheap energy creating an industrial competitiveness against other European states. With the “Energiewende” policy eventually leading to the complete closure of all nuclear power plants and more intermittent electricity production from wind and solar, Merkel happened to create the highest beta to the previous world order and globalisation.

It follows naturally from this that a fragmentation game in which the US and Europe are slowly disentangling itself from production and trade with China and Russia will lead to Germany being the biggest loser. With ending of China’s last growth stage and Russia’s disintegration from Europe, the entire economic model of Germany has changed for the worse. The structural issues might not be as bad as during the “sick man of Europe” days of the 1990s, but the failure of building a digital economy and cluster of powerful technology companies combined with the car industry ongoing its biggest competitive change in 70 years are exposing the Germany economy to key risks.

A weak Germany is obviously bad for European growth and investors betting on European equities should hope for Berlin to wake to the new era of geopolitics realizing that it must dramatically change its economic model and invest heavily into that change.

Siemens Energy is a mirror of Europe right now

Siemens Energy shares are down 6.5% today as the energy equipment maker announced that it expects full fiscal year loss of €4.5bn on new charges related to design problems in its newest wind turbines affecting 4% of its installed capacity. While the wind turbine business is unprofitable and undergoing big challenges, the order intake is still looking good and especially in its Grid Technologies segment which saw orders rise 64% y/y in Q3 2023 (ending 30 June). In many ways, Siemens Energy represents Europe. There are some things that are horribly wrong and other parts which are doing really well. With analysts expecting FY24 EBITDA of €2.46bn due to strong growth in its other businesses outside wind turbines the equity valuation is as low as 5.3x on forward EV/EBITDA for a business with overall order growth of 54%. In US equities, investors are willing to pay steep prices for the hope of growth from AI technologies while in Europe investors are dumping companies such as Siemens Energy despite growth and a technology portfolio that is necessary for the energy transition.