A powerful rally
The UK and European equity markets have had strong rallies since their troughs six months ago. Back then, anxiety was at its highest—for good reasons.
In the UK, the country was in the throes of former Prime Minister Liz Truss’ ill-fated economic plan, and market turmoil threatened to engulf the pensions industry. In Europe, governments feared energy shortages believing the war in Ukraine would switch off large swathes of the industrial complex during the winter.
Since then, a new government has restored some stability to the UK, while in Europe, mild weather and high levels of natural gas storage mean energy shortages are unlikely this winter.
Thus, in both instances, a crisis was avoided. And the good news kept coming. Wholesale natural gas prices retreated, benefitting both regions and lifting hopes that inflation would soon peak too. Bond yields declined from their autumn peak, underpinning equity valuations. For Europe, the reopening of the Chinese economy, to which it is heavily exposed through exports, is an additional boost. As a result, European business and economic sentiment have improved three months in a row.
Avoiding the worst-case economic scenario, the peaking of bond yields, coupled with light positioning in both regions led to powerful equity rallies, as institutional investor inflows returned. The FTSE All-Share Index is up 17 percent and the MSCI Europe ex UK Index is up 22 percent in local currency terms since their autumn troughs.
UK and European indexes rally from their troughs
The line chart shows the FTSE All-Share Index and the MSCI Europe ex UK Index from March 2018 through February 8, 2023. Both indexes declined in 2022; the FTSE in response to poorly received economic policies in the UK, and the MSCI due to fears of energy shortages caused by the Russia-Ukraine war. Since the end of 2022, both indexes have rallied strongly.
Source - RBC Wealth Management, Bloomberg; data through 2/8/23
Challenged outlook despite improvements
While crises were averted in the UK and Europe, their economic backdrops are likely to be subdued.
The International Monetary Fund calculates the UK will have the worst economic performance of advanced economies, including Russia, in 2023. It estimates a 0.6 percent contraction due to the challenges we have been highlighting for months—energy shortage and cost-of-living crisis, much higher interest rates, and the fallout from Brexit.
The UK government has announced it will go ahead with the increase in energy bills planned for April 2023, suggesting the cost-of-living crisis is unlikely to let up anytime soon. Interest rates have risen to four percent, and could go slightly higher still, up from 0.1 percent in December 2021, and while market expects the Bank of England could cut rates a little by year end, monetary policy is likely to be remain restrictive for a while. Higher taxes and reined-in fiscal stimulus complete the unpalatable picture.
As for Europe, economic activity is picking up nicely. The Composite Purchasing Managers’ Index (PMI) for the eurozone reached 50.2 in January, up from December’s 49.3 and the highest level since June 2022. Bloomberg consensus 2023 GDP expectations improved marginally to 0.15 percent growth compared to the 0.1 percent contraction estimate at the beginning of the year.
But with the European Central Bank (ECB) leaning on an aggressive monetary policy and pre-announcing another 50 basis point interest rate hike, the path for higher rates seems clear. Unlike the Fed, whose dual objectives of full employment and low inflation leaves it some wiggle room, the ECB is solely focused on inflation. So long as core inflation is much above its two percent target, interest rates will likely be maintained.
The Bloomberg consensus expectation is for rates to peak at 3.5 percent, a high level for an economy that had functioned on negative interest rates for eight years. Energy price caps are in place in most countries until April 2024—perhaps too short a period for businesses to have the confidence to invest.
Earnings risk
Corporate earnings in the UK and Europe have been resilient so far thanks to COVID-19-induced pent-up demand at a time consumers were flush with cash from stimulus efforts. Thanks to this backdrop, corporates were able to pass through higher input costs, lifting margins which are at an all-time high.
But the situation has evolved. Pent-up demand has largely been exhausted, supply chain disruptions have largely resolved themselves, and inventories have been built up. Corporate pricing power may erode, particularly as there is increasingly widespread evidence of downtrading to cheaper goods. Importantly, we believe the impact of central bank monetary policy tightening will be felt with a lag, reducing demand. Lower revenues could translate into lower margins for companies with a high fixed cost base. In short, corporate earnings upgrades are likely to be difficult to come by.
The pause that refreshes?
The easy stock market gains may be behind us, as the economic backdrop is likely to remain challenging, more so in the UK, but also in Europe. Complacency may have set in—the VDAX, an index of volatility on the German stock market index, is at its lowest level since January 2022. Finally, geopolitics, in the form of tensions between the U.S. and China, may act as a headwind in the short term.
Following months of institutional investors’ outflows as prospects darkened last year, some money is likely to return. Overall valuations for the FTSE All-Share and the MSCI Europe ex UK remain attractive, at 10x and 14x 2023 estimated earnings, respectively, much below those in the United States. This should keep these regions on investors’ radar.
However, some pockets of the market appear expensive. Our national research provider estimates that European non-financial cyclical stocks seem to be discounting GDP growth rates of over four percent. Moreover, it argues that the equity valuation of China-exposed European capital goods companies relative to the market is at an all-time high.
We believe low valuation levels compared to the U.S. warrant some positioning in the UK and Europe for a globally diversified portfolio. However, we would be selective and wouldn’t chase the rally. More than ever, the old adage ‘investor patience will be rewarded’ is likely to be true.