Euro Bear or Bull?

I’ve been bearish Europe all last year, and rightfully so.

Just look at the chart.

But, this year we seem to be looking at a whole different story when we look a the markets in Europe. The European markets have been displaying extreme strength.

I wanted to take an objective look at the big picture data to break down what’s underneath the surface and whether this strength is really something we can rely on.

Macro Data

We track various point in the Macro Data from consumption to inflation to sentiment data. Given below is Europe’s Macro Data Scorecard, color coded to track the data for the changes.

At first glance, it quite clear that the data still has some ways to go to improve. In fact, if you compare this to the US data, some of the points are much worse.

• Consumption - measured largely by Retail Sales, the data is still printing as a negative change. Now, while this is a welcome change to denote that demand destruction is taking place, it also means revenues for companies are deteriorating.

• Employment - The unemployment rate has decreased but remains at 6.5% which is much higher than the US.

• Inflation 

  • Producer Prices - Data at the PPI level has improved quite drastically since October 2022. A major factor in this is energy costs declining. However, if our thesis around energy is correct, then it’s only a matter of time before energy costs start to rise again. Nevertheless, even at the current levels the PPI for Europe remains very high. The US PPI is in the high single digits.

  • CPI - Yet another data point that remains much too high. From what we see in the US, we know that inflation rolls over and then can re-accelerate. Again, energy costs remain a key issue here and it’s likely with the conflict still ongoing, we will see the CPI remain sticky in the high single digit levels. The ECB much further to go in terms of taming inflation.

• Sentiment Data - Sentiment data in terms of consumer confidence and other survey data continues to remain negative for the Eurozone.

Currency

We saw the Euro dip below parity last year and since then there’s been considerable recovery but, not enough. The Euro still remains below 1.1 to the USD which is below the long-term average of 1.19. It didn’t even dip to these levels during prior recessions.

The Currency has regained some of its strength because the USD has been weak over the last few months. But, I’m not convinced that the USD is done with it’s strength. Even if I’m wrong, there are other issues to consider where the EUR is concerned. I don’t think people fully appreciate the extent to which the oil sanctions will hit the Euro. Russian sanctions will have an impact on the demand for the currency and we will likely see a decline in rates once again.

Interest Rates, Money Supply and Central Bank Policy

The Eurozone still remains far behind the US in terms of Interest Rates and Money Supply. Whereas in the US Interest Rates are now closer to 4%, the EU has some catching up to do. They started hiking after the US and haven’t exactly been as aggressive. There’s a reason for that. They realize that their economy is far more fragile than the US and aggressive hiking could break a great many things.

Money supply as well continues to remain positive whereas the US has just experienced it’s first month of negative money supply growth.

However, looking at the balance sheet, we find something quite interesting. The ECB’s balance sheet has actually reduced more than that of the Fed’s.

So there’s some liquidity coming off there but, with interest rates still at low levels, stocks still have a tailwind with slightly better financial conditions than in the last few months. However, as the Balance Sheet shrinks and the Interest Rates increase, we’re likely to see the rising cost of capital wreak havoc on stocks.

The ECB continues to be determined in reducing inflation, and most of their messages have been far more hawkish than the Fed, and for good reason. The level of inflation still remains far above their 2% target and Real Rates (Interest rates adjusted for inflation are still negative).

This is what the ECB posted today and even on Valentine’s Day, they haven’t failed to send a message!

Earnings

The one thing actually driving the current market uptrend in Europe is earnings. But, the one thing that could actually be the cause of its demise could also be earnings.

This earnings season has been kind to the European stocks. With extremes that Europe has had to endure in 2022, estimates were reduced drastically and this has lead to a fair number of “beats”.

But there are reasons for concern here:

• The Average Decline in EPS during recessions is -55% on the DAX vs. -25% on the SPX. During 2001, the DAX saw an EPS decline of -101% vs. -47.5% for the SPX.

• The gross margin for European equities are far below that of the US

• The Sales growth and EPS growth for European Equities remain lower than the US

• The Euro Stoxx 50 is projected to have earnings declines in 2023 of -13.48% and -3.84% in Q1 and Q2 respectively.

Recession?

There seems to be consensus that Europe will narrowly avoid a recession. Germany is already looking at recession territory and the EU is not far behind. Whether the EU technically dips into a recession or not, will largely depend on the situation with Energy. Much of the relief in the numbers have come from the fact that the situation with energy seems to be somewhat under control.

But, things are getting somewhat dire again. Russia is cutting production by 500,000 barrels per day and it’s quite unlikely that the OPEC+ will increase production targets even with the revised forecast of a higher demand for oil this year.

Natural Gas also accounts for 20% of Europe’s electricity generation. While Europe has had somewhat of a milder winter leading to less consumption of heating oil and gas, they will have to replenish stocks at some point and that will drive up prices once again. This will likely happen during later half of the year, when rates have reached 3.5% and companies are faced with a double whammy of higher cost of energy and higher cost of capital.

Even if the EU doesn’t dip into a recession, they are faced with stagflation - low growth and high inflation. Their inflation is still at exorbitant levels and this will take a while to subside. There’s no reason for European stock not to experience an earnings recession and this can very well pull them into a real recession.

Where do we go from here?

I find it a little puzzling that the big banks are bullish on Europe. I know the situation has improved and in the interim we are seeing stocks rally. But, this doesn’t look largely sustainable to me given everything we know about the macro, oil, sanctions, the conflict and earnings.

I had every reason to bearish of Europe last year and I’m finding it hard to shake that feeling this year as well.