Posted by Jeffrey Buchbinder, CFA, Chief Equity Strategist
Thursday, September 14, 2023
Key Takeaways
- Economic growth is weakening in Europe while inflation remains stubbornly high, leading to waning earnings momentum.
- Meanwhile, European equity markets have a very small allocation to technology, making it difficult for the European stock market benchmarks to keep up with those in the U.S. when the domestic technology sector is rallying.
- Our technical analysis work points to the U.S. and Japan offering better opportunities than Europe, even though European equity valuations look very attractive.
Five Reasons to Be More Cautious on Europe
Here are five reasons LPL Research is becoming more cautious on Europe:
- Weakening Economic Growth. Eurozone GDP in Q2 was revised down to a 0.1% expansion from the previous 0.3% estimate, which pales in comparison to what the U.S. (+2.1% annualized) and Japan (+4.8%) produced during the second quarter.
Meanwhile, more recent data such as the purchasing managers’ index data (see below) and economic surprise indexes, show that the European economy is weakening. In fact, the Eurozone composite PMI in August reflected the deepest contraction in nearly three years, while nearly every economy in the region reported weaker readings, led by Germany. Europe faces energy, labor, and geopolitical headwinds and lacks the innovation engine that can propel stronger growth like the U.S., and to an extent, Japan enjoys.
Bottom line, we believe Eurozone activity will be subdued for the rest of the year and Germany is likely entering recession. Inflation remains stubbornly high, which sparked the European Central Bank’s (ECB) decision to hike rates another quarter point this morning.
- Bearish U.S. dollar call tougher to make. As the global economy slows and markets potentially become more volatile, the greenback may get a safe haven bid. Further, the interest rate differential that we had expected to push the euro currency higher against the dollar has not done so, partly due to the U.S. remaining a more attractive investment destination and partly because the ECB may be done hiking rates earlier than we had anticipated. In fact, markets may increasingly start pricing in rate cuts in Europe, removing the interest rate differential with the Federal Reserve as a bearish dollar catalyst. Finally, from a technical analysis perspective, the dollar appears poised for a breakout to the upside through a major level of resistance in the 104-105 area.
The other side of the story is European exporters should garner some support from a weaker currency (making their goods more attractive to U.S. buyers). Regardless, even though the case for USD weakness over the intermediate term looks like a strong one, our conviction in calling a short term dollar decline is low, removing a potential boost for European equities.
- Earnings momentum in Europe is waning. Europe’s economy outpaced most expectations in late 2022 and early this year amid fears of an escalating energy crisis as the war in Ukraine continued. Rising earnings expectations coincided with that outperformance, at least until this summer. Since July, earnings estimates have fallen, coinciding with recent ratcheting lower of economic growth expectations in the region. With recession increasingly likely in Europe in the near term, the current consensus expectation for 6% earnings growth from MSCI Europe in 2024 may be too high. We would anticipate the U.S. and Japan delivering stronger earnings growth than Europe over the rest of this year.
Europe having a tough time keeping up with big tech. The MSCI Europe Index has just a 6.6% weighting in technology, compared to more than four times that amount (27.7%) in the U.S. Although the technology sector’s 40% year-to-date rally may be a bit overdone, in rising markets it’s tough for European markets with a more defensive sector mix to keep up.
- Europe doesn’t look good on the charts. From a technical analysis perspective, Japan and U.S. equity markets look better than Europe right now. The relative strength of the MSCI Europe Index, shown below in local currency, has broken down and has not been able to generate any positive momentum (the Europe index in dollar terms looks very similar). Japan, on the other hand, in yen terms, has been generating some nice outperformance recently against the U.S. and Europe, with higher highs and higher lows. In fact, U.S. investors in Japanese markets that have hedged currency have generally done better than they have done in the U.S. equity markets, based on the S&P 500.
Conclusion
LPL Research holds a slightly positive view of developed international equities, due to cheap valuations and the upbeat assessment of Japan. Meanwhile, the European economy is weakening, conviction on a bearish U.S. dollar move is difficult, European earnings momentum is waning, big tech gives the U.S. an advantage, and our technical analysis work suggests the U.S. and Japan are currently more attractive investment destinations than Europe. So for now, we’ll stick with our bullish Japan and neutral U.S. equities positions, but suggest increasing caution toward Europe.
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