It’s time to buy in Europe – In search of Alpha

Many economic indicators point to a global slowdown. Unprecedented tailwinds in the form of free money and tax debauchery have turned into major headwinds. The Federal Reserve’s recent quantitative tightening is having an effect that mirrors and reverses the wealth effect of Quantitative Easing. Since the end of QE, asset prices across the board have fallen dramatically. Even more than the rise in interest rates, the contraction in the money supply caused the deflation of assets last year.

Michael Cembalest of JP Morgan Asset Management writes in his latest letter that developed economies are emerging from “the largest combined monetary and fiscal experiment in history” and that “a major growth slowdown is brewing in the United States and Europe”. We agree, but in our opinion, Europe will be in better shape than North America.

Declining equity prices and rising cost of capital, combined with the end of unprecedented fiscal stimuli around the world all point to a slowdown in economic activity or even a recession. However, much of this was priced in by the markets. Some markets, especially in Europe, overreacted. It’s time for investors to separate the wheat from the chaff. Not all businesses are equally vulnerable to a downturn.

European relative fiscal discipline

It may come as a surprise, but Europe has been a model of fiscal discipline, at least compared to the United States and Japan. Eurozone fiscal discipline rules have prevented its members from going too far, even during COVID-related lockdowns.

In 2021, the combined gross debts of eurozone governments amounted to “only” 95% of gross domestic product. This represents an increase from 86% in 2010 and well above the agreed target of 60%. However, Europe’s rising public debt looks puny compared to our recent “drunken sailor” deficit spending. In the United States, public debt has climbed to 137% of GDP, far exceeding that of Europe while public revenues have increased by 40% since 2017! The largest debtor in the developed world remains Japan with a ratio of 225%.

The abundance of cheap capital is a curse. It inevitably leads to excesses with long-term negative side effects. Japan is a good example. Its economy is still trying to recover from the bursting of the speculative bubble of the late 1980s that left banks with unmanageable defaults.

Another example is the Japanese chip industry, which has also suffered from monetary excesses. In his book The Chip Wars, Chris Miller describes how cheap and plentiful capital led to overinvestment in Japanese semiconductor production. An inevitable slowdown in global demand followed and crushed capacity utilization, productivity and factory profits. Since then, Korean and Taiwanese competitors have dominated the business.

Closer to home, the Fed’s policy of incredibly cheap money has encouraged politicians to embark on a spending spree not seen since World War II. With the cost of debt being so low, borrowing has become irresistible. Deficits soared and debt reached tens of trillions of dollars.

Today, the Fed’s aggressive interest rate hike is finally scaring some lawmakers. Even before the cost of borrowing exploded, servicing the national debt already accounted for 15% of federal spending. Rolling over existing debt alone will be very painful.

Like it or not, fiscal discipline is coming to America, whether through lower spending or higher taxes. We have no choice. Europe, for its part, continues to manage with already high fiscal pressures and reasonably high public deficits. Unlike the United States, Europe is not expecting a fiscal shock.

A warm winter in Europe, after all

Europe is showing impressive determination and efficiency in its response to the Russian invasion of Ukraine. Quick action prevented an immediate energy crisis. Natural gas from Norway, the Netherlands, the United States and Qatar replaces Russian supplies. Floating LNG terminals are being built at a record pace. 20 coal-fired power plants have been reactivated in Germany. Huge wind farms are being erected in the North Sea. France is modernizing its nuclear facilities. Helped by mild temperatures, it now seems that Europe is going through winter without too much disruption. Already gasoline prices have returned to “pre-war” levels on the Old Continent.

A more assertive Europe

The alarming headlines of last summer are giving way to cautious optimism. The European economy is holding up. The German Chancellor even predicts that her country will avoid a recession in 2023. Investors are returning to the stock markets.

The past year has not been a good year for world peace. It was also not a good year for dictators. In my opinion, Putin miscalculated and is now mired in a war of attrition. Xi Jinping has turned around and relaxed zero-COVID policies. The ayatollahs’ regime in Iran is facing serious social unrest. Turkey’s Erdogan is fighting hyperinflation.

All in all, European democracies have shown more resilience than is believed. Putin’s humiliation has stiffened the backbone of Western democracies. Europe is reaffirming itself. Europeans themselves are perhaps the most surprised by the outcome of the war in Ukraine. Despite the usual vilification from conservative governments in former communist countries in Eastern Europe and insults between President Macron and Prime Minister Meloni, Europeans have shown remarkable unity. They rallied to the common enemy. NATO, an entity that lost its raison d’être after the collapse of the Soviet Union, was also revived by the new threat from the East.

European stocks are cheap

Since the first QE in early 2009, US equities have traded at a premium to the rest of the world. Ben Bernanke’s “wealth effect” has not spread to overseas assets. Each subsequent QE, up to and including the “mother of all monetary stimuli” brought about by the pandemic response in 2020, has reinforced this price differential between US equities and the rest of the world.

Investors like to use recent trends to project the future. But the premium valuation of US equities only seems sustainable if you look back a decade. The chart above shows that overseas markets were trading in line with the S&P before the massive and repetitive Fed interventions triggered the valuation gap of recent years.

European central banks ended up copying the Federal Reserve’s stimulus policies, but with a time lag and less conviction. The ECB only launched QE in March 2015, six years after Bernanke’s first move. Most of the speculative money then was already chasing technology companies in North America. Even after last year’s global stock price correction, the average S&P P/E was still 17.5, while the average for EMU countries was just 11.9. The UK market is trading at less than 10 times earnings. Japan, which traded at more than 60 times earnings in the late 1980s, ended the year at 12.5 times projected earnings.

There seem to be good reasons for these valuation discrepancies. American technological superiority looms large among them. But, as this tech bubble bursts, the world may soon realize that companies headquartered outside of North America aren’t necessarily worth less, especially if they’re truly global players. .

Nor does a good business necessarily become bad because of a downturn in the economy. On the contrary, the intrinsic value of a great company can become more evident in more difficult times. An initial sale due to a temporary downturn in the industry sometimes creates unique buying opportunities.

Going into the new year, Europe looks better positioned than the US from a macro perspective. Cycles tend to be more extreme in the New World. At the same time, European stocks are cheap, having already priced in a major economic downturn that may not materialize. Because European stock markets have been less affected by FAANG-like excesses and unicorn speculation, the risk of a bullish surprise may be much higher than that of further sell-offs on the Old Continent.