European equities on the upswing

By Dr. Jens Ehrhardt, founder, main shareholder and CEO of DJE  

The outlook for the European economy this year is likely to be largely determined by one factor: The low growth forecast for Europe will improve as soon as the European Central Bank (ECB) cuts interest rates. In fact, inflation in Europe has fallen more sharply than in the USA. The core rate there is still at 3.8% (up 0.4% on the previous month, which was higher than expected). This means that the conditions for an interest rate cut in Europe are more favourable than in the USA. In fact, the Europeans should - for the first time - cut interest rates before the Americans. However, that much independence is rather unlikely.

It is also unlikely that European shares will be able to catch up quickly compared to American shares. This is because US stock markets are generally the most expensive in the world. The price/earnings ratio is around 21 on expected earnings, although the expected increases of around 10% this year appear by no means certain. If one assumes that the economy will only grow by 1-2% in real terms, profit increases of 10% are hardly possible from an economic point of view. 

If the expected earnings growth does not materialise, the price/earnings ratio of US equities would be closer to 23, which would be the highest historical overvaluation of US equities in terms of the price/earnings ratio compared to European equities. But even in terms of the price/book value ratio, US equities are at over 3.5 significantly more expensive than European equities at around 1.5. 

On the one hand, European equities are cheaper than US equities, while on the other hand European interest rates are significantly lower than US interest rates. From this perspective, the equity risk premium comparison is much more favourable for Europe than for the USA. In times of very low interest rates (in the USA two years ago at 0.5%), the very high US equity valuations of today could have been justified. Today, however, after a tenfold increase in short-term interest rates, the high price/earnings ratios of the past hardly seem justified. 

In the meantime, real interest rates of over 2% in the USA and over 1% in Europe are again being derived from the expected inflation rate of 2%. In the past (e.g. 2000 and 2007), the US economy deteriorated when real interest rates were above 2%. High real interest rates slow down the economy, low real interest rates or negative interest rates stimulate the economy. Low interest rates are encouraged by an expansion of the central bank's balance sheet. In the course of the US crises (financial and Covid crisis), the Americans have increased their Fed balance sheet more than tenfold from 800 billion dollars to 8.9 trillion dollars. One can imagine that if the US central bank balance sheet is reduced in the future (to date, a good USD 1 trillion has been spent on bond sales and thus balance sheet reduction) and if new borrowing is reduced in the future - as announced this year - the decisive stimulus for the US economy and the US stock market will be missing. 

The Europeans have reduced their central bank balance sheet total by a greater percentage than the Americans (also through the repayment of bank loans). This could be the reason why the European inflation rate is significantly lower than the American inflation rate (especially in the area of core inflation). Germany is suffering the most from this restrictive ECB policy. 

Through the EU's New Generation Fund, countries such as Italy, Spain and France are receiving billions in subsidies that do not have to be repaid and further low-interest loans. As a result, the economy in the Mediterranean countries - similar to the USA - is developing significantly better than in the northern European countries, which receive little or no subsidies. Against this backdrop, the economic and equity market outlook in Italy, Spain and France is likely to remain better than in Germany and the northern European countries. Italy has been the best performing stock market internationally since the beginning of 2022. Even when currency changes are taken into account, the US and Japanese stock markets were no better than Italy. The Mediterranean countries are therefore likely to continue to be economically favoured. Especially if the ECB lowers interest rates. 

To summarise, the economic and stock market prospects in the Mediterranean countries are likely to be relatively good by international standards. Interest rates are already lower than in the USA and are likely to be cut more sharply, particularly if the German economy is expected to deteriorate. In terms of fiscal policy, the EU will also provide a strong stimulus to the economy by probably increasing deficits – which were hardly permitted when the EU was founded. In view of the high wage increases in Europe, the consumer goods economy in particular could pick up more strongly. With inflation falling at the same time, real wage growth in Europe will also increase. The outlook for the consumer goods economy therefore appears favourable, particularly in the Mediterranean countries.