European equities is the new consensus trade. Is the optimism justified?
As we entered the new year, European equities enjoyed the widest consensus, with many believing that the worst was behind and that relatively low valuations represented a better value than other markets. The weight of evidence points to a reversal of this trend and fresh lows ahead.
As we entered the new year, European equities enjoyed the widest consensus, with many believing that the worst was behind and that relatively low valuations represented a better value than other markets. The #Eurostoxx 50 index has rallied by over 30% since its October low, outperforming the S&P 500 and other major indexes. However, the weight of evidence points to a potential reversal of this trend and possibly fresh lows ahead.
Latest data shows that the European economy is shrinking more than anticipated, with bellwether Germany recording a -0.4% decline for Q4 2022. Inflation remains stubbornly high, with the core metric actually increasing to 5.3%. Adding to this challenging stagflationary environment, the #ECB has no other choice but to continue to tighten by raising rates and stall its bond purchase program, as the majority of member states demand more energetic action to contain inflation (https://bit.ly/3G1M3g7).
However, perhaps more importantly, Europe’s key woes are political and geopolitical in nature. Italy, the third-largest economy in the union, is hurtling toward a fiscal crisis, with domestic political pressure pointing to more expansion of the already-large deficit, setting the country on a path of confrontation with other member states. Since 2014, the ECB has bought over 100% of all Italian debt issued. With an annual issuance of 400+ billion euros, it is unclear how Italy will continue to finance its debt without either full mutualization or fragmentation of the monetary union. As we’ve surmised in past posts (https://bit.ly/3IwChD2), a #Eurozone fiscal crisis is probably the most underestimated “gray swan” scenario ahead.
On the geopolitical side, the Ukraine war appears to be far from a resolution, and a more general deglobalization trend is not boding well for a region that is largely dependent on trade and is a net importer of energy. The EZ’s deteriorating balance of trade is a testimony to that.
The disconnect between European equity prices and fundamentals is starkly represented by the gap between the index and the 10-year German bond (see chart w/equity index inverted). The “jaw” is likely to close at some point soon, and given the aforementioned inflation problem, it is more likely to require a hastened retracement of equity prices. Self-delusion is the greatest of human talents, and there is no greater application of that than to finance & economics.
Disclosure: Not investment advice. Do your own research. Hold all assets mentioned. Twitter @pietroventani for more timely comments and updates
