Europe’s energy supply is under severe pressure, and the 8.9% inflation rate in the eurozone seems to be cushioned only by sharp increases in interest rates, which could push the European economy into recession. Is Europe still the continent you want to be in as an investor?
Although the European economy had a relatively good second quarter, with economic volumes up 0.7% on the first, concerns for the second half of the year remain high.
“Inflation, the European Central Bank’s interest rate hike and, of course, concerns about energy supply continue to hang like clouds over the economic landscape. The war in Ukraine has hit the global economy hard, but it is in Europe and some emerging markets that the downward pressure on prices from the sharp decline in PMI activity indicators is strongest,” said Seema Shah, chief strategist at Principal Global Investors.
Europe less attractive than the US
Like any geopolitical risk, this situation increases investor uncertainty. But with the threat of a harsh winter, Shah daid the investment proposition for Europe looks much less attractive than that for the US so far.
From a fundamental perspective, European large caps will be challenged by their global exposure. As the US economy slows down rapidly, the outlook for Europe and many emerging markets is bleaker,” said Shah.
Yet not everyone is negative about Europe. Tom O’Hara, portfolio manager for European equities at Janus Henderson, said he understands that many investors are avoiding Europe, but he doesn’t think this is entirely justified. “The situation has indeed become extremely complex, but if I were allowed to invest freely, I would continue to allocate to Europe.”
Opportunities lie in the energy sector
“Europe”, said O’Hara, “has many globally operating multinationals that have been making money around the world for decades and dealing with every imaginable currency. The energy sector is particularly attractive at the moment.”
O’Hara said he is not convinced by the argument that any recession will reduce demand for energy. “The energy sector has been punished by the rise of ESG, but we sometimes forget that these companies are essential to the success of the energy transition. Furthermore, oil and gas companies are well placed to absorb inflation for customers and protect the portfolio,” said O’Hara.
Despite recent share price rises, energy companies are still attractively valued, according to O’Hara. He cited Shell as an example: “The stock is cheap, pays a lot of dividends and is known for its buybacks. Even if the oil price were to fall, the price currently paid for the stock is justified. Only an extremely deep recession could change that,” said O’Hara.
Remarkably, European equities are the only region in the world to have posted a positive return since the day Russia invaded Ukraine. The Stoxx 600 index has risen by 2%. Since then, the MSCI AC World has lost 5% and the S&P 500 has returned 3%.
European equities rose again this week following strong results from a number of companies. Investors were encouraged by signs that corporate earnings were coping with soaring inflation and slowing growth.
The ECB
The state of European stock markets in the second half of 2022 will depend heavily on ECB policy. The era of negative interest rates seems to be coming to an end. This interest rate hike will take place against the backdrop of a slowing European economy, “and will certainly not be accompanied by a festive smile,” said Shah.
“The ECB is tightening as it faces a potentially severe stagflation shock that is almost entirely out of its control, while at the same time facing an Italian political crisis that could be described as a serious country risk. Of all the central banks in developed markets, none is, in my view, in a worse position than the ECB.”
Moreover, euro area governments have reached the limits of their ability to mitigate the impact of the inflationary shock, while they cannot escape additional stimulus measures either. The ECB, however, seems unwilling to put aside its anti-inflation objective. This is what Gilles Moëc, chief economist of the AXA Group, wrote in his weekly Macrocast.
Despite stronger than expected GDP growth in the eurozone in the last quarter, Moëc sad he expects a contraction to be inevitable in the period ahead. The extent of this contraction, he said, depends on how much gas Russia is prepared to deliver to the EU.
Moëc said he believes the ECB’s policy is crucial now that a recession is on the cards, not least because of gas supply rationing. “For the time being, it seems that the ECB will continue on the path it has chosen, namely to raise interest rates further. It may take some time for the hawkish rhetoric to subside, but the market is impatient.”