Is it time for the European Renaissance?

Key takeaways

  • The global response to the COVID-19 pandemic may act as a catalyst for inflation in Europe as politicians promise billions of euros in recovery money and seek to reduce the huge debt burden faced.
  • Although we do not believe that inflation is imminent in the near term, we do believe it is important to question the factors that have led to the decade-long run of US growth and bonds.
  • Other factors, including the rise of environmental, social and governance (ESG) considerations and the dominant role Asia is expected to play in the 21st Century, offer Europe potential impetus to outperform the US.

For years now, momentum has propelled US growth stocks higher and higher still, with hefty valuations to match soaring share prices. Meanwhile, value managers have been lying face down in a darkened room for a decade, waiting to be fired. Now, we believe they should feel confident enough to emerge, blinking into the light and say, “good morning Europe”.

It would be foolish to suggest that allocating to US growth for the past decade was a mistake. On the contrary, we have watched from the side lines as the Nasdaq and tech stocks hit record highs time and time again, giving investors no reason to turn their backs on such phenomenal momentum. Since quantitative easing (QE) began, following the Great Financial Crisis of 2008, the world of equities has belonged to the US and to growth stocks as well as bond proxies. This ultimately led to years of underperformance by the value cohort. However, we believe that the sands are already shifting and the quite astonishing bull market in momentum stocks is potentially on its last legs. It is not just because many European stocks are cyclicals, nor simply because Europe is ‘cheaper’ on basic valuation metrics, such as price-to-earnings ratios. Rather, we believe that a catalyst has been identified: COVID-19.

COVID-19: a catalyst for inflation?

To be more precise, we believe that the global response to the COVID-19 pandemic may act as a catalyst for inflation in Europe. The pandemic has given politicians the air cover to take control of the levers, wrestling them away from central banks. With those levers, we believe that politicians will set about creating inflation. Why? The world is facing a colossal debt burden that politicians would be thrilled to see diminished by the effects of inflation. A coordinated response to the COVID-19 pandemic offers this opportunity.

LONG-TERM EUROPEAN INFLATION EXPECTATIONS HAVE BEEN FALLING


Source: Bloomberg, data from 30 April 2004 to 11 September 2020. Daily mid-price swap rate used. Note: The 5-year EUR inflation swap rate is a common measure used by central banks and dealers to assess the market's future inflation expectations.

The European response to the pandemic has commanded ‘helicopter money’ with central banks seeking to boost the economy with cash straight into people’s pockets: £10 vouchers to the public to ‘eat out to help out’ and above-inflation wage increases for key workers in the UK alone. In May 2020, the European Union (EU) unveiled a ‘Next Generation EU’ recovery package to the tune of €750bn.[1] That is to say that we will see direct transfers from the frugal North, led by Germany, to the spendthrift South, including Italy and Spain. It is fair to say that this magnitude of direct money transfer would have never been considered without the pandemic and, yet, we would not be surprised to see more of the same to come. The return of inflation is crucial to all of this: if we are correct in our thinking and inflation returns, we believe that Europe and other value cohorts may begin to compete with the US.

However, it is important to say that we do not forecast inflation today, tomorrow or even this year. What we are saying is that there is a danger of ‘the unthinkable’ happening – that is, a return of inflation – while the world is currently calmed and sitting comfortably in deflation and disinflation. And while bond managers might think us mad – ‘just look at the shape of the yield curve!’ – we believe it is time to, at least, question what has been the winning trade for the past 10 years.

Geopolitical support

Another catalyst for Europe is at the geopolitical level. Europe is, for want of a better phrase, ‘having a good pandemic’ while some may argue that the US is having a disaster. This reflects much more than political personalities, although some may argue that this could be a major contributing factor. It also reinforces our view that we are witnessing the end of the American century and the beginning of the Asian century. To contextualise this, the nineteenth century was dominated by Europe and British Imperial reign, which was soon to be overtaken by America in the twentieth century. Today, Asia is on the rise. By 2040, it has been forecast to generate more than 50% of world GDP and could account for nearly 40% of global consumption.[2] In our opinion, Europe is much better placed to capitalise from the rising Asian century than the US.

Winning the green race

We must also consider that a new competition is underway: the green race. The winners have been declared in the tech race and, while the US has reigned supreme on this occasion, we believe that Europe is well placed to be leaders in the ESG space. The EU has put a great emphasis on sustainability, with the Green Recovery Fund devoting nearly €550bn to green projects. This is the greatest climate pledge ever made and reflects the EU’s desire to maintain momentum and to propel its position as leader in all matters ESG. The US, on the other hand, has taken to ESG matters more slowly.

It is our belief that markets are approaching a major turning point and that the ‘buy growth stocks and forget about it’ investing style is perhaps, finally, facing a genuine challenge. One of the features of our investment philosophy, and therefore the stocks we favour, is strong balance sheets and cash generation. This can sometimes appear old fashioned, not least during the love affair of recent years with ‘disruptors’ and other cash-absorbing adventures. Perhaps old-fashioned financial tenets tend to prove their worth at times such as this. We believe that the COVID-19 pandemic will come to be seen as having ushered in a different political zeitgeist and, with it, hope for some of the traditional value sectors in the stock market. It may even mean the unthinkable: that ‘value Europe’ now has the potential to outperform ‘growth US’. Perish the thought.

 

 

[1] Communicated from the European Commission to the European Parliament in Brussels on 27 May 2020

[2] McKinsey Global Institute discussion paper: Asia’s future is now, as at 14 July 2019

 

Glossary of terms

Bond proxy: An investment product that replicates the performance of a bond but that is not a bond. This term can be used to describe equities, such as consumer staples and utilities, which often display ‘safe’ and predictable returns that are similar to bonds but may have higher yields than the bond market.

Price-to-earnings (P/E): A popular ratio used to value a company’s shares. It is calculated by dividing the current share price by its earnings per share. In general, a high P/E ratio indicates that investors expect strong earnings growth in the future, although a (temporary) collapse in earnings can also lead to a high P/E ratio.

Yield Curve: A graph that plots the yields of similar quality bonds against their maturities. In a normal/upward sloping yield curve, longer maturity bond yields are higher than short-term bond yields. A yield curve can signal market expectations about a country’s economic direction.

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