Macro: Sandcastle economics
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European equities amid maximum uncertainty
Peter Garnry
Chief Investment Strategist
Summary: In today's equity note we show how European equities are being pushed to new lows relative to US equities as the maximum uncertainty in Europe is driving down equity valuation through the precautionary principle. Equities are about the future of cash flow and if the future has become totally unpredictable then investors must lower valuations on European equities driving up the equity risk premium. European equities are now valued at a 30% discount to US equities but it is still difficult to argue that this is a buying opportunity in European equities. We also cover the agriculture chemicals industry where especially American and Canadian fertilizer producers are reaping massive tailwinds from lower natural gas prices compared to competitors in Europe.
Can you model the future amid the war in Ukraine?
Global equities are only down 11% as of Friday’s close prices despite galloping commodity markets and large scale war on European soil. The probability of a recession has gone and the range of outcomes in the Ukraine war is almost infinite. It is the true definition of maximum uncertainty, which is a huge liability for equity valuations as equities are discounting growth and future cash flows. In its essence the war in Ukraine is the collapse of the future because the future has become so uncertain that under the precautionary principle of risks equity valuations have no other way than to go lower pushing up the equity risk premium.
The war in Ukraine has pushed European equities to a new relative low against US equities measured in EUR total return terms since 1999. It really has been 15 years of hardship for European companies in terms of performance against the US and at one point investors will consider the opposite trade, but in the short-term European equities are too uncertain.
In today’s session we were much lower in European before news came that Russia would cease its war on Ukraine if the Ukraine would make a change to its constitution to ensure neutrality (not entering any blocs such as NATO or EU), acknowledge Crimea as Russian territory, and recognize Luhansk and Donetsk as independent states. These demands are essentially the same as previously communicated by Russia, but the market is relieved sending equities higher because it is being interpreted as an opening for potential peace in Ukraine. Intraday volatility today shows that short-term sentiment is driving everything because “the future cannot be priced”.
European equities are now valued at a 30% discount to US equities on a 12-month forward EV/EBITDA which of course reflects that the US economy is better shielded against the fallout from the war in Ukraine. The US has less risks in terms of energy and food security. One thing to note when seeing these European vs US equity valuation spreads is that the US equity market has a much larger share of technology stocks and which has increased over time. The best comparison is to take an entire sector.
If we compare European industrials vs their peers in the US we see that the market was pricing European industrials higher throughout the pandemic indicating that things were improving relatively better for European industrials compared to US industrials. The trade reversed the summer 2021 as the energy crisis in Europe accelerated and the war in Ukraine has blown out the discount to almost 20% again and a new record low. Is it time to buy European equities?
Given the maximum uncertainty regarding the outcomes of the war in Ukraine and sanctions against Russia we believe the most prudent thing is to be overweight US equities vs European equities. However, there are pockets in the European equity market that will do well such as green energy, defense, and mining companies.
Agriculture chemical companies are a hedge amid food crisis
As we have pointed out in several of our latest equity notes, the commodity sector, logistics, cyber security and defense stocks are the themes investors are rotating into. Inside the commodity trade and the energy crisis in Europe, an opaque industry such as agriculture chemicals is doing well. Or the US companies are doing well. Fertilizer prices have exploded higher over the past year due to the higher natural gas prices which is a key input in making fertilizer. However, the increasing spread between natural gas prices in the US and Europe, have given US and Canadian fertilizer producers an advantage over their European competitors which can also be seen in their relative performance. As long as the Ukraine war continues and we have upward price pressure on agriculture crops then this is trade that investors will continue to make. The jump higher in food prices has the unfortunate unintended consequence of potentially creating a humanitarian crisis around food security and this mobilize political forces to end the war in Ukraine as food security is a serious game for any country. The table below shows the companies in the agriculture chemicals industry with a market value above $5bn
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