Europe: Teetering on the brink of a recession

The case is even more severe over in the UK, where both headline (4.6% YoY) and core inflation (5.7% YoY) remain well above the Bank of England’s (BOE) 2% target, while services inflation continues to remain sticky. (Figure 2). 

Figure 2: Services inflation remains sticky, particularly in the UK

Although markets expect inflation to continue declining gradually, we believe Europe is unlikely to reach inflation targets anytime soon, as the bulk of the recent deceleration in inflation was driven by falling energy prices, given the high base effects from last year. We also believe that getting core inflation down to the 2% target would prove challenging because of sustained wage growth, coming in at 4.6% YoY in the second quarter of 2023. Labour markets have remained tight with the unemployment rate hovering close to its historical low at 6.5%, and services inflation continues to remain sticky.

Besides the inflation conundrum, economic growth in Europe is expected to remain sluggish.  Consumer spending continues to weaken in the face of rising borrowing costs and higher prices, as evident by Europe experiencing 13 consecutive months of negative retail sales growth on a YoY basis. 

Other economic indicators are also showing signs that Europe’s economy is slowing down. If we look at the Eurozone’s manufacturing sector (accounts for a fifth of the GDP), it has been shrinking with manufacturing PMI stalling since the middle of 2022. Meanwhile, services PMI has also declined into contractionary territory in recent months, indicating that the momentum in the services sector is diminishing as well.

Figure 3: Eurozone PMI data remains in contractionary territory 

The overall slowdown in Europe stands in contrast to other developed markets (Figure 4) such as US and Japan. Therefore, we see divergence amongst the developed markets, with Europe expected to produce the weakest GDP growth in 2024, making it the most susceptible to a potential mild recession should economic conditions worsen.

Figure 4: Projected GDP growth for major developed markets

Restrictive monetary policy to impact Europe more drastically than US

While the ECB has likely reached the peak of its interest rate cycle, we do not hold the view that the ECB would cut rates early next year, due to sticky inflation as mentioned earlier. In our view, we believe a prolonged restrictive stance would be necessary to ensure that inflation moves back to its 2% target, so as to avoid a policy mistake that could reignite inflation to the upside.

With this in mind, refinancing challenges are expected to surface in the public debt market as we progress into the next three years, as refinancing volumes for bonds issued by entities in Europe would rise from the EUR 460-470 billion in 2022 to 2024, to over EUR 500 billion in 2025 and 2026 annually as they mature (Figure 5). As these companies refinance at higher rates in the next few years, the rise in interest costs would test the resilience of corporate borrowers and cause a squeeze on their balance sheets.

Figure 5: Bond refinancing volume of Europe-based non-financial companies (as of Sep 2023)

To make matters worse, as compared to the US where over 80% of the corporate borrowings comes from public debt markets primarily at fixed rates, over 70% of corporate borrowings in Europe are sourced from banks, primarily at floating rates. 

The reason behind the high percentage of corporate borrowings from banks at floating rates was because bank lending was supported by government guarantee schemes during the pandemic and the Russia-Ukraine war. Back then, interest rates from bank lending were also low, causing many firms to shift away from debt issuance from the public market. 

However, in this high interest rate environment, companies which borrowed at floating rates not only face refinancing challenges, but also incur higher interest expenses and debt servicing costs. This could reduce their profit margins and potentially increase the risk of a default. Therefore, as the delayed impacts of monetary policy take effect, we foresee that Europe would be more severely impacted than the US, since the transmission of interest rates in Europe would occur more rapidly.

Slowing growth in China to weigh on Europe’s economic activity

China’s lingering economic challenges would also have a significant impact on Europe’s economic growth. For instance, China’s imports have remained weak (Figure 6), and this would negatively impact Europe via reduced exports to China. After all, China is Europe's third-largest export partner, representing around 9% of EU exports.

Figure 6: China imports remain sluggish

Beyond which, Europe has also fallen behind in terms of technological innovation, as seen from the number of world class patents in cutting-edge technologies, which are dominated by US, China and Japan. It would be crucial for European countries to invest heavily into the area of research and development to increase productivity growth over the long-run, or risk losing out to other countries.

Structural reasons warrant a fair P/E downgrade, maintain 2.5 Stars “Neutral” for European equities

Although valuations are currently trading at a discount to its 10-year historical average (Figure 10), we believe a combination of sticky inflation, restrictive monetary policy, and slowing growth in China paints a gloomy picture for Europe. Moreover, longer-term structural issues make European equities look less attractive compared to its developed market peers. 

Figure 10: STOXX 600 is trading at a discount to its historical P/E

With these long-term structural challenges in mind, we believe there is a valid justification to downgrade the fair P/E rating for the STOXX 600 Index from the current 16.5X to 14X. Based on our revised fair P/E ratio of 14X, we project a target price of EUR 553 for the STOXX 600 Index, translating to an upside potential of 15.9% by the end of 2025 (Table 1). We maintain the Star Rating for Europe at 2.5 Stars “Neutral”.

Nevertheless, if investors still wish to seek exposure to European equities, they may consider the Eastspring Investments Unit Trusts - Pan European SGD. They may also consider the Fidelity European Smaller Companies A-EUR, if they wish to seek exposure to small and mid-cap European equities. Alternatively, they can consider a passive ETF such as the Vanguard FTSE Europe ETF (NYSE:VGK).

Beyond Europe, we believe there are more attractive opportunities to be found elsewhere such as Japan and the Asian Tigers. On a sectoral basis over in the US, we prefer high quality companies, Big Tech and the semiconductor sector.

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Table 1: Projections for STOXX 600 Index

Table 2: Recommended products for Europe

Figure 11: STOXX 600 Index Price vs EPS

Declaration:

For specific disclosure, at the time of publication of this report, IFPL (via its connected and associated entities) and the analyst who produced this report hold a NIL position in the abovementioned securities.