The lower prices reflect the economic challenges present in the region and the larger downside risk to the baseline assumption of a relatively short and mild recession.
- The weakening macro economic outlook and falling prices means that continental European equities and credit markets look increasingly attractive on historical and relative basis.
- The region is likely to fall into a recession given the impact of both high energy price and tightening financial conditions as the European Central Bank combats inflation pressures.
- Caution is warranted given the risk to corporate earnings expectations and further spread widening in credit.
European assets have unsurprisingly fallen out of favour as the headwinds from the energy crisis, elevated inflation and tightening financial conditions wash over the region. However, compelling absolute and relative valuations across equity and credit markets have raised investor interest.
European equity have much better valuations now than at the start of the year and are relatively attractive compared to the U.S. equity market. The forward price-to-earnings (PE) ratio on the MCSI Europe ex-UK Index has fallen to 11.4x from 16.5x at the start of 2022, well below its long run average (14.7x). However, we expect that further downgrades to the earnings outlook will outweigh the upside to multiples.
Consensus earnings are forecasted at close to 4% for 2023 and running higher than the average earnings delivered between 2011-2019. This is somewhat surprising given the headwinds from the looming recession and cyclical nature of the equity market.
The market capitalisation of the MSCI Europe ex-UK index has higher weights in financials, industrials and materials sectors compared to the U.S. (37% of market capitalization versus 21%). This implies that the headwind from slowing demand could have a greater impact on earnings. The more attractive valuations may provide some offset to a declining earnings forecast but we find little else constructive on the outlook for continental European equities.
More recently there has been renewed concerns on the stability of the banking system. The cost of insuring against corporate default – credit default swap spreads – for many banks has increased. The health of the banking sector has always been paramount to the region as there is greater reliance on banks for financing. In Europe, around 60% of corporate financing is via banks, compared to 30% in the U.S.
However, regulatory oversight of the banking system has increased since the last banking crisis, as has the balance sheets of banks. For example, core tier 1 capital ratios have increased from 5-10% in 2009 to 15% today.
Healthier balance sheets and regulatory stress testing may mitigate systemic risk to the region's banks, and rising interest rates support the sector. But bank profitability will be challenged by a slowing economy and non-performing loans will likely increase.
The 4.3% yield on European investment grade (IG) bonds is the highest since early 2012 and creates a better entry point for return and income. However, spreads on European credit, like U.S. credit, remain relatively tight when compared to the economic backdrop and do not appear to fully reflect recession risks.
Exhibit 1: European investment grade spreads have widened more than U.S. markets
The spread on European IG at the end of September was 225bps and while this is wider than average over the last 10 years, it is still some way below the peak of the global financial crisis or the European debt crisis.
Our expectation is that the single currency bloc will experience a relatively mild recession given the increasing levels of fiscal support. When combined with the favourable market conditions in prior years, this suggests a shallower default cycle and lower credit risk being reflected in todays spreads, and explain why they may not retest the peaks of the prior recession.
However, there may be further spread widening to come as the European Central Bank (ECB) maintains its aggressive tightening stance and inflation pressures remain severe in Europe. The official policy rate in the eurozone has risen from zero to 1.25% in quick succession and market pricing suggests that it will reach 2.5% by March 2023. Rising rates and the potential for the ECB to enter its own quantitative tightening program exposes the downside risks to potential returns from European credit.
Relative to the U.S. market, European credit spreads have widened further – European IG spreads are around 130bps wider from the start of the year compared to the 67bps increase in U.S. IG spread – and just like the equity market, represent a better value proposition. But the more severe economic downside risks that could present themselves in the European economy suggest a more cautious approach.
Valuation metrics across both European equities and credit markets are the most favourable they have been in some time, whether compared to their own history or to U.S. markets. However, the lower prices reflect the economic challenges present in the region and the larger downside risk to the baseline assumption of a relatively short and mild recession.
The cyclical nature of the equity market is less appealing at a time when investors should be taking a defensive stance in portfolios and could be subject to further earnings downgrades.
Meanwhile, even as spreads on IG credit have widened, the expectation of higher rates and possible quantitative tightening by the European Central Bank could see spreads widen further. Moreover, the negative feedback loop on the banking sector creates a risk that perceived financial stress could become actual financial stress in the sector.