European Equities: Too Many Headwinds Make the Stocks Unattractive

Launching the Investment Radar

We’re launching our Investment Radar product today that will be replacing our Macro Notes. The Investment Radar will continue to leverage the same tools from our Macro Notes: fundamentals, valuations, macro, technicals and quantitative analysis in service of providing investment ideas.

Like the Macro Notes, the Investment Radar product will help us assess what assets merit inclusion in our Model Portfolio. While some ideas may be opportunistic, they still may not be added to the portfolio as our current positioning and risk tolerance would also play important roles.

For example, in today’s Investment Radar note, we find that European stocks currently offer an attractive shorting opportunity. However, given our already defensive allocation in our portfolio, we’re not looking to add this short to our exposure.

Different from the Macro Notes, for those ideas that don’t fit well with our current portfolio, we’ll still provide an actionable setup based on technical analysis for members who want to participate based on the thesis laid out and find the investment suitable for their portfolio.

Please enjoy our first Investment Radar note below and let us know your thoughts by commenting below the article. Your feedback is highly appreciated.

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Summary

• Analysts expect European equities to post a modest rebound in revenue in the second-half of the year. We believe those estimates are too aggressive amidst unfavorable inflation dynamics.
• Weakness in manufacturing and consumer spending is turning protracted, with organic growth unlikely to materialize without ECB easing. Persistent inflation makes that a tough call, however.
• While disinflation increases the odds of ECB easing, it poses a headwind for margins. European corporates have proven adept at passing costs to consumers, shielding their profitability.
• The technicals look unfavorable for European equities today, with a weekly bearish divergence signaling that the rally is getting exhausted. We find the stocks unattractive.

Unfavorable Inflation Dynamics Dominate European Stocks

Since late-September, European stocks have surged relative to their U.S. counterparts fueled by optimism that the energy crisis wouldn’t throw the European economy into a deep recession.

European stocks also benefited from China’s re-opening since November. China is a big customer to many of Europe’s largest publicly-traded companies.

As concerns around Russian gas supply waned, and expectations grew that China would flood European manufacturers with orders, the euro also rose in a reflection of economic strength.

Since late-April, however, European stocks have weakened relative to U.S. ones, while the euro has kept strengthening. That divergence spells trouble for European equities.

Recent euro strength has been driven by rising rates relative to U.S. ones, as sticky inflation has forced the ECB to keep hiking. It no longer reflects upside to the economy, a risk for the stocks.

In today’s Investment Radar we explore this unfavorable inflation dynamic afflicting European equities that makes the stocks unattractive.

European cyclical businesses face many headwinds that include a slump in manufacturing, persistent inflation, a hawkish central bank (ECB) and weak Chinese demand.

Industrials and Consumer Discretionary are big sectors in Europe and provide useful information regarding investor expectations on the the state of manufacturing and consumer spending.

Despite the headwinds, analysts expect a rebound in revenue for Industrials and Consumer Discretionary businesses in the second-half of the year, after a slowdown in the first-half.

We believe that optimism is misplaced as we document in the note.

No Rate Cuts => No Stimulus => No Growth

The contraction in European manufacturing following breakneck growth rates seen when the economy re-opened is just getting started. The weakness was worsened by the ECB’s rate hikes.

Prior slumps in manufacturing have seen interest rates ease, as the priority turns to stimulating the economy and restarting the manufacturing cycle, Europe’s growth engine.

It’s difficult to see a manufacturing rebirth without the ECB reversing its hawkish stance. We expect more weakness, as today’s high inflation regime delays any ECB easing.

Moving on to the European consumer, retail sales adjusted for inflation (i.e., on a real basis) have been contracting for close to a year now, consistent with their U.S. counterparts.

With the fiscal stimulus and reopening now in the rear-view mirror, organic spending growth will prove hard to come in a backdrop of high inflation and high interest rates.

European rates have been rising relative to U.S. ones, as the ECB has turned more aggressive to fight inflation. While inflation in the U.S. has been decelerating, that’s not been true in Europe.

Without rate cuts from the ECB, it’s unlikely that consumer spending will recover. The market is expecting the ECB to hike twice through year-end, followed by one cut in the first-half of ’24.

Europe’s equity market is assuming a best case scenario where inflation retracts quickly without job losses, giving ample room for the ECB to cut and stimulate earnings growth.

We don’t see that scenario as likely because in a fiscally-induced inflationary regime, disinflation implies weakening demand, offsetting the positive from growth in discretionary income. [1]

Disinflation also poses a headwind for profit margins. As prices rise, corporates pass through more than a fair share of costs to consumers, boosting their profitability.

When inflation is driven by precautionary savings and stimulus, corporates are even more able to boost margins, given increased pricing power amidst a surge in pent-up demand.

The evidence shows that a big part of Europe’s inflation was driven by corporate profiteering.

The positive relationship between inflation and profits in Europe helps explain why earnings growth has proven more resilient than in the U.S. amidst global monetary tightening.

We don’t find European stocks attractive given unfavorable inflation dynamics:

• If disinflation proves more rapid than estimated, we expect poor revenue growth realizations and margin compression given weaker pricing power; rate cuts may not see P/E expansion
• If inflation picks up, the ECB would turn more aggressive, raising interest rates to weaken consumer spending and root out sticky inflation, a negative for earnings and P/Es
• If the disinflation is moderate, a long pause by the ECB can be expected. But the rise in real yields as nominal rates hold steady and inflation expectations fall would limit the P/E upside [2]

European stocks could see some upside following any decisive stimulus from China, given the trade linkages that exist between the respective economies. We’re keeping an eye on the policy newsflow.

To conclude, while we find European equities unattractive, we’re not considering shorting them in the Model Portfolio given our already defensive positioning.

For those interested in expressing a negative bet on European stocks, below we provide a potential setup for shorting EZU, the iShares MSCI Eurozone ETF.

We spotted a weekly bearish divergence for EZU spanning most of this year (i.e., higher high in price with lower high in RSI). That hints that the European stock market rally is getting exhausted.

A similar bearish divergence in 2021 anticipated the big swoon in stocks seen the following year, as the re-opening optimism ran out steam (i.e., weakening momentum) ahead of monetary tightening.

EZU is at a key horizontal resistance zone ($47-$48), that’s acted as support throughout 2021, and turned into resistance in 2022. It also acted as resistance in 2018.

Given the bearish divergence, we expect a pullback as price approaches key resistance with weak momentum. The current $47-$48 zone offers an opportunity to short EZU.

$41 offers a good target. It’s served as the midrange level for the past 2 decades and has triggered the most reactions. For a stop loss, we recommend the $49 level.

Footnotes

[1] All things being equal, falling inflation (i.e., price growth) can boost discretionary income growth as a smaller share of household earnings growth are consumed in expenditure growth.

[2] Real yields would likely rise if the ECB pauses rates because nominal rates would stay fixed, while inflation expectations fall, putting downside pressure on earnings and P/Es. Rising real yields reflect worsening financing conditions, a headwind to growth.

Real Yield = Nominal Yield – Inflation Expectations