SUMMARY
European growth could suffer by more amid any global slowdown. While we see some value in these markets already, investors may hold back from overweighting regional shares for now.
- The global economy’s upward momentum is fading – Given Europe’s sensitivity to external demand dynamics, the loss of momentum in global economic activity could make investors more cautious about adding exposure to European assets in the short-term unless there were to be some surprisingly positive geo-political developments.
- Record gap between manufacturing and services sector activity – Historically, when the gap widens beyond -5 points, the services activity measure troughs within zero and four months. Excluding the pandemic, the average trough was 46.7 for services sector activity and 44.8 for the composite PMI output, suggesting that in the short-term the direction of travel is likely to be towards weaker PMI readings as the contraction in manufacturing begins to affect services.
- Europe will improve, but this is likely to be a 2024 story – We think that economic activity is likely to remain constrained in the aftermath of one of the largest monetary policy tightening episodes in history, unless inflation pressures were to decline very rapidly, or China’s reopening story were to regain momentum. But in the medium term, the balance of risks between headwinds and tailwinds suggest that Europe will be in stronger position to outperform.
- Opportunities are presenting themselves in medium- and small-cap equity markets – The latter, especially compared to US 10-year real rates, look fairly-valued, and have significantly strengthened their balance sheets.
- Relative valuations – Compared to expensive large-caps, European small-caps look cheap both on an absolute and a relative price to earnings (P/E) basis. The price to sales (P/S) ratio shows that European small caps screen cheap relative to European large caps.
- Conclusion – Following a year of clear underperformance in 2022, as we search for opportunities in this volatile market environment, we would argue that European small-cap equities are becoming more attractive on many metrics. Fundamentals look strong and valuations are cheap. Despite the likelihood of a global economic slowdown in coming quarters, and despite the banking system adopting a more cautious attitude towards these smaller firms, we think that a point will come at which removing this underweight will be justified.
