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Since the start of the war in Ukraine, the bears have been very vocal, playing a mournful tune about Europe while not considering what is already priced in and by downplaying the (monetary and fiscal) political reaction to the current crisis and the ability of companies and households to adapt to a new inflation regime. Our analysts opted not to indulge in this pessimism and kept a constructive stance on European equities. Looking ahead, they continue to see upside in European equities, albeit smaller after the recent bull run, and identify pockets of opportunity in select thematics and sectors for 2023. In short, they won’t dance to the bear’s tune.
Inflation to peak, monetary policy to pause
China reopening and easing of supply chain issues
Don't dance to the bear's tune
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This page contains opinion of the Cross-Asset Research department of Societe Generale. It does not necessarily reflect the views of the other departments of Societe Generale nor the official opinion of the Societe Generale group. This content has been prepared for informational purposes only and is not a recommendation or an offer or solicitation for the purchase of sale of any security or financial instrument. Investors should not take any investment decision based on the summary material provided here, which should be read in the context of the underlying research report made available to subscribers. Please click on the full report for risks and disclosures.
Excess savings: a resilient European consumer
The China credit impulse (i.e., the additional quantity of credit injected into the economy) is now well into positive territory. Historically, such impulses have been leading indicators for European cyclical sectors. With an average lead of 10 months, the rebound ten months ago could correspond once again to the recent outperformance in cyclical sectors relative to defensives – a trend that could continue if history repeats itself.
Consumption in Europe has remained relatively resilient despite price increases and uncertainties surrounding the outlook. European governments have used fiscal expenditure to mitigate the impact of high energy prices.
Lastly, European households have had access to the excess savings they have accumulated since 1Q20. SG’s economists put these excess savings at €990bn for the euro area (7.6% of GDP). They note also that Euro area household deposits remain very high compared to pre-COVID levels at 62% of GDP vs 59% at end-2019.
All lights are green for Eurozone small caps, and they may benefit from several tailwinds:
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This page contains opinion of the Cross-Asset Research department of Societe Generale. It does not necessarily reflect the views of the other departments of Societe Generale nor the official opinion of the Societe Generale group. This content has been prepared for informational purposes only and is not a recommendation or an offer or solicitation for the purchase of sale of any security or financial instrument. Investors should not take any investment decision based on the summary material provided here, which should be read in the context of the underlying research report made available to subscribers. Please click on the full report for risks and disclosures.
1) a COVID vaccine - Europe is the epicentre of the second wave and thus COVID continues to weight on its economy. Except Utilities, all the European sectors have underperformed their global peers. Most of them are trading with a discount. A vaccine would therefore be a catalyst for European equities.
With the top-line decline seen in 2020, companies have also logically reduced investment. However, the capex-to-sales ratio has slightly increased. The energy transition, as well as the digitalisation of the economy, are likely to support further corporate investment in the future.
The easing of zero-COVID measures could well result in larger outbreaks in more places, which in the short term will continue to dampen consumption and sentiment. However, an exit in 2023 looks almost certain now and we expect normalisation of activity to start sometime next year, pushing GDP growth to 5%, with the risks skewed to the upside.
12-month forward P/E ratio - Europe vs US
Discount/premium – European sectors vs US peers
Source: National sources, Refinitiv, SG Cross Asset research/Economics
Yet our strategists do not expect a recession as measured by EPS because: a) corporate leverage has fallen and debt has moved from the private into the public segment; and b) the labour market is still at its best level in 50 years, suggesting top-line growth will stay robust.
Favoured thematics in 2023
Automobiles and components: the sector has started its transition towards electric vehicles and autonomous driving. It is also more tilted towards the luxury end of the market. And while profitability is back to a historical high, valuations are in distressed territory and already pricing in a lot of bad news. The sector is trading at close to a historical low level, with forward P/E at 5.7x, against 13.9x for the market, representing a 60% discount versus a 10y average of 40%.
Retailing specialised: while the sector has changed materially over the past few years, with internet-linked companies now accounting for 57% of the MSCI Europe Retailing Specialised index, valuations have been slashed following the sector’s underperformance last year (-47%). Even the more traditional speciality retailers (still 26% of the sector) are back to historically low valuations.
Transportation: this sector has been a big beneficiary of the COVID crisis, supported by the increase in online shopping but also from its key position in the logistics value chain to limit supply chain disruption. Moreover, the sector does not appear to be impacted by elevated raw materials prices. The sector is trading on a forward P/E of 10.6x, which is close to a historical low and a 20% discount to the market level.
Secular shifts on ‘Reshoring’ and ‘Greener America’
Automobiles and components: the sector has started its transition towards electric vehicles and autonomous driving. It is also more tilted towards the luxury end of the market. And while profitability is back to a historical high, valuations are in distressed territory and already pricing in a lot of bad news. The sector is trading at close to a historical low level, with forward P/E at 5.7x, against 13.9x for the market, representing a 60% discount versus a 10y average of 40%.
Retailing specialised: while the sector has changed materially over the past few years, with internet-linked companies now accounting for 57% of the MSCI Europe Retailing Specialised index, valuations have been slashed following the sector’s underperformance last year (-47%). Even the more traditional speciality retailers (still 26% of the sector) are back to historically low valuations.
Transportation: this sector has been a big beneficiary of the COVID crisis, supported by the increase in online shopping but also from its key position in the logistics value chain to limit supply chain disruption. Moreover, the sector does not appear to be impacted by elevated raw materials prices. The sector is trading on a forward P/E of 10.6x, which is close to a historical low and a 20% discount to the market level.
Central banks are well aware of the risks to the stability of the financial system as it is opened up to new forms of digital money, as the Bank of England puts it. That is why the Bank is already considering, in such a scenario, placing limits on their use during a transition period. Other central banks might share that view.
Also, the unemployment rate is at an all-time low in the eurozone. This has pushed up wages and total compensation and is therefore supporting real disposable income.
China credit impluse in positive territory, a support to cyclicals
Global Supply Chain Pressure Index (GSCPI)
Sources: New York Fed, Bureau of Labor Statistics; Harper Petersen Holding GmbH; Baltic Exchange; IHS Markit; Institute for Supply Management; Haver Analytics; Refinitiv; authors’ calculations
Inflation to peak, monetary policy to pause
With the inflation peak apparently behind us and central banks looking for the right spot to pause, we should probably see less velocity on bond yields in the coming year. Societe Generale expects the Fed rate to peak at 5.13% and the ECB rate to peak at 3.0% in 2Q23 and then pause. As a consequence, our strategists expect US and German bond yields to continue to rise in 1Q23 before falling.
Over the past three years, European companies have raised almost €700bn each year in the credit market, and this year has begun at the same pace. The STOXX600 net debt-to-EBITDA ratio has come down to 1.5x from 2.0x just a year ago. At this level, it is basically in line with the long-term average since 2000 and slightly below its pre-COVID level.
12-month forward P/E ratio - Europe vs US
Total debt, net debt and cash
China reopening and easing of supply chain issues
COVID-19 led to major supply chain issues in many sectors and has contributed to slowing global trade, lower production and higher prices. According to the New York Fed Index, pressure on the global supply chain has eased substantially over the last few months, even if the situation has not yet normalised.
Eurozone: energy base effects to shave 2.6pp off HICP from Nov. 2022 to Mar. 2023
Based on STOXX 600 and 10y German bond yield. Macro regime: 15-year average of German GDP growth minus the absolute level of the spread between the 15-year average of German inflation and 2.5%. Source: Datastream, IBES, SG Cross Asset Research/Equity Strategy
Favoured thematics in 2023
European Green Deal: Our analysts see the energy transition as a key theme for 2023 and beyond as global GHG emissions have yet to peak, highlighting the long journey ahead. Despite the energy crisis, the European Union continues to advance on this front and announced during COP 27 its plan to cut emissions by 57% by 2030, a 2% increase from its previous goal, notably via a ban on selling new fossil fuel cars by 2035.
European tourism: European tourism was hit hard by COVID-19, while 2022 has already seen recovery, with a strong increase in hotel RevPAR (Revenue Per Available Room) and a recovery in international arrivals to Europe. According to the European Travel Commission, even in a downside risk scenario, international arrivals should recover in the coming years.
European capex: Capex has risen by 11% yoy (STOXX 600 excluding Financials) and are now back to the pre-COVID level. However, capex has overall remained flat over the last 10 years and is actually at an historical low on a relative basis to sales. In our analysts view, capex remains a key theme for the coming years given a decade of underinvestment and the need to accelerate both the energy and the digital transition.
In the euro area, Societe Generale’s macro team estimates that inflation should peak just below 11% at the turn of the year (4Q22). However, uncertainty remains high given the volatility in wholesale energy prices. Indeed, energy remains the largest contributor and may see some accelerating base effect on the downside by March 2023. On wage growth, the pattern is very different between the US (6.4%) and the euro area, where wage growth is muted (2.4%).
Even if retail sales are holding up relatively well in the eurozone for all the reasons cited above, many investors are nonetheless concerned about low consumer confidence in the euro area. Therefore, investors have sold off Consumer Discretionary sectors, with multiples moving from 16.3x at the start of the year to 12.6x currently. Despite the recent outperformance, the Consumer Discretionary sectors are still trading below the ten-year average discount to Consumer Staples (17.8x), which benefits from recession fears.
European EYBY spread: earnings yield ratio - bond yield
Based on average performance of European sectors in euro in total return. Cyclical = Chemicals, Capital Goods, Construction Materials,
Semiconductors, Metals & Mining, Transportation, Auto & Comp, Banks. Defensive = Pharma & Biotech, Food Products, Beverages, HPC, Source: Datastream, Bloomberg, SG Cross Asset Research/Equity Strategy
Source: Datastream, MSCI, IBES, SG Cross Asset Research/Equity Strategy
Source: Bloomberg, SG Cross Asset Research/Economics
The European equity market is currently trading at a 12-month forward P/E of 11.9x, up from 10.4x at the late September bottom but down from 15.8x at the start of the year. All the P/E contraction seen January has been the result of the rise in the German bond yield from -0.2% to 2.1%. The European EYBY spread is now at 6.25%, an 18-month low and below its 15-year average (6.65%).
Source: Datastream, IBES, MSCI, SG Cross Asset Research/Equity Strategy
12-month forward P/E ratio - Europe vs US
Discount/premium – European sectors vs US peers
US household savings rate (% of disposable income)
Source: Bloomberg, SG Cross Asset Research/Economics
Sources: New York Fed, Bureau of Labor Statistics; Harper Petersen Holding GmbH; Baltic Exchange; IHS Markit; Institute for Supply Management; Haver Analytics; Refinitiv; authors’ calculations
The first part of the year has been very challenging for European equities: low growth, high inflation, a strong rise in bond yield and low support from Chinese credit. Also, these headwinds may soften or even turn into tailwinds by the end of the year.
European equities are currently trading on a 30% discount to US equities, in line with the discount seen during the Great Financial Crisis in 2009 (it even reached 35% in early March). Among other factors, the discount is attributable to the fact that the European market’s sector composition is different than that of the US market.
All European sectors are trading at a discount to US peers, except for Healthcare. And for most sectors, the discount is bigger today than it has been for the last ten years, with the exception of Healthcare, Communication Services and Energy.
In crypto, our equity analysts see a ‘crypto divide’ which largely excludes banks from crypto innovation on the one side, with crypto fintechs and DeFi (decentralised finance) on the other. Banks are dissuaded from holding crypto on their balance sheets (for trading or lending purposes) due to penal regulatory rules. Banks are also wary of offering their clients crypto-based transaction services (like current accounts or credit/debit cards) because of the treatment of crypto as a taxable asset rather than a currency.
Source: Factset, SG Cross Asset Research/Quant Strategy
Source: National sources, Refinitiv, SG Cross Asset research/Economics
S&P 500 VS Russell 2022: the profit margin for the S&P 500 has just reached an all-time high while margins for Small Caps are just above break-even levels
12-month forward P/E ratio - Europe vs US
US household savings rate (% of disposable income)