Trouble persists for Europe – downgrade to 2.5 Stars “Neutral”

• Europe’s energy crisis has been the root to its troubles, driving up inflation to highs and has curtailed production output. 

• The ECB has responded with rate hikes, marking a shift away from the negative rates adopted through the last 10 years, which is likely to weigh on growth. 

• The energy crisis has also taken a toll on production, and hence growth, as electricity prices have become too expensive and as energy rationing is implemented.

• Furthermore, the energy crisis is unlikely to be solved quickly which means inflation is likely to remain elevated and production to remain hampered.

• Finally, a weakening economy warrants an earnings downward revision, which translates to unattractive valuations for European equities.

• Valuations have become less attractive with an upside potential of just 18.3% as of 12 Sep 2022. Hence, we downgrade European equities to a rating of 2.5 stars “Neutral”.

Since our last update on European equities in June, the outlook has further deteriorated. What changed in the past quarter – an increasing likelihood of a complete cessation of energy supplies from Russia, and an increasing number of reports of production cuts. 

We downgrade European equities to 2.5 stars “Neutral” as the economy has weakened on all fronts. Our case for a downgrade lies in the fact that firstly, the aggressive rate hike cycle is likely to weigh on growth. Secondly, the energy crisis has resulted in production output cuts which translates to declining growth. 

Thirdly, the energy crisis is unlikely to be solved quickly which means inflation is likely to remain elevated and production to remain hampered. Finally, a weakening economy warrants an earnings downward revision, which translates to unattractive valuations for European equities.

Aggressive rate hikes to manage inflation is likely to slow growth

Europe has borne the brunt of the impact of the Russia-Ukraine war, having to face a myriad of issues including the disruption of food supplies, raw materials, and the energy crisis. The severity of the impact has been a result of Europe’s huge dependence on Russia, especially for its energy needs. (Figure 1)

Figure 1: Russia is the largest supplier of energy for Europe

At the beginning of the war, markets had hopes that Russia would not cut off energy supplies to Europe, referencing back to the cold war when Russia did not do so. However, the situation has simply deteriorated, culminating in a complete gas supply cut-off through the Nord Stream 1 gas pipeline in early September 2022. This move by Russia is in retaliation to the sanctions Europe imposed on Russia, including the ban on oil imports and the halt of the Nord Stream 2 gas pipeline project.

With the energy shortage plaguing Europe, prices have skyrocketed, driving up inflation to highs of 9.1% in August 2022. (Figure 2)

Figure 2: Inflation hit highs of 9.1% in August 2022

The multi-decade high inflation has sent alarm bells to the European Central bank (ECB), which has since responded by raising its interest rates by 50 basis points in July 2022, and most recently by 75 basis points just on the 8th of September 2022 taking the target effective rate to 0.75%. (Figure 3)

ECB’s President Christine Lagarde also hinted during her speech on the 8th of September that policymakers may implement two or three more jumbo sized rate hikes in future meetings. The significance of this is that this stance is a change from what the ECB has adopted through the last 10 years of maintaining negative rates.

Figure 3: ECB policy target rates have seen the largest hike in September

As such markets are now expecting much higher rates, more than double of what was expected in May 2022 (Figure 4). 

Figure 4: Rate hikes expectations of the ECB policy rate has increased since May

Higher interest rates raises the borrowing costs for businesses and consumers, resulting in slowing economic growth thus increasing the likelihood of a recession in Europe. 

Economic growth hit as the energy crisis puts a lid on production 

Apart from higher borrowing costs, businesses are further squeezed as they face rising prices. Electricity prices have risen by 43.1% YoY in July and have been seeing above 20% YoY rise in prices since November 2021 (Figure 2). As a result, businesses and producers across industries are suffering and are cutting back on production as electricity gets too expensive and as energy rationing is imposed. 

One of such industries affected is the aluminium industry, where producers intend to further cut production by as much as 50%, bringing aluminium production levels even lower. (Figure 5) With a key input like aluminium in shortage, the ripple effects has deeper consequences such as affecting the production of autos which is the largest industry in the largest European economy Germany. 

Furthermore, this is likely to have long-term ramifications on the European economy and global supply chain, as restarting closed aluminium smelters is difficult and costly. 

Figure 5: Aluminium production is already at lows in July, which would decline more as producers further implement cuts

Hence, with the various industries facing an energy shortage, the production of raw materials such as metals, food and others are all affected. The reduced production likely will lead to a supply shortage spiral, which we think is likely to further contribute to inflation being elevated. Additionally, the reduction in production also results in a decline in economic growth. 

Energy crisis to persist and is unlikely to be solved quickly

Rate hikes are traditionally used by central banks to bring down inflation. However, in this current situation where inflation is supply shortage driven, the task to manage inflation gets more complicated. 

One might argue that as production and consumption falls, it could cool inflation. However, we think that the energy shortage will persist in the next few years, which will keep inflation elevated and hinder the European economy from any form of robust economic growth. Moreover, the ECB has revised up their inflation forecasts and cut GDP forecasts. (Figure 6)

The reason why the energy shortage is likely to persist is because Russian gas cannot be replaced easily, as firstly, capacity needs to be built at Europe’s ports to receive liquefied natural gas (LNG). Secondly, the global supply of LNG remains tight, which was further exacerbated after a fire at the Texas LNG plant in June knocked out close to 20% of US LNG exports. Thirdly, the nuclear deal with Iran is unlikely to see progress in the coming months due to political agendas. 

Figure 6: ECB’s inflation forecasts raised while GDP forecasts decreased

Related article: Low inflation is gone for good. Here’s how to position for a new era of higher inflation.

All in all, the root of the troubles in the EU is its energy crisis, with symptoms of this including skyrocketing inflation, production cuts, and the supply shortage spiral of all kinds of goods including food, metals and more. 

Rate hikes are unlikely to be a one-stop solution to inflation, and the European economy has weakened on all fronts. Therefore, we remain cautious on Europe, till we see easing pressures on the energy supply front.

A weakening economy warrants an earnings downward revision

Considering the energy crisis, weakening consumer strength, declining production, and inflation, an earnings downward revision is logical based on our analysis. However, consensus earnings estimates have instead seen an upward revision through this year thus far. We think this is overly optimistic, further increasing the likelihood of downside risks to share prices. (Figure 7)

Figure 7: STOXX Europe 600 2022 EPS upward revision driven by sectors like energy, resources, and travel.

This phenomenon is because the upward revision of earnings for sectors that do well due to rising energy and materials prices are significantly high. While in contrast, very few of the sectors that are impacted by the war such as autos and industrials saw downward earnings revisions. 

Hence, we differ from the consensus and expect that the hit to earnings growth is likely more than what the market expects. Moreover, when tracing the overestimation of estimates by consensus, we find that in years of huge uncertainty the overestimation is most pronounced (Figure 8). Hence, there is a likelihood for actual earnings to miss estimates and disappoint the market. 

Figure 8: Market estimates overshoot actual earnings by 22% on average

Valuations have become less attractive

We think that markets are under-pricing the impact of the Russia-Ukraine war on earnings, hence our earnings estimates are lower than consensus by 20-30% across 2022 to 2024. We forecast earnings growth to see the largest negative impact in 2023 of -5% YoY growth, accounting for a full-year effect of the war. We also expect 2024 to have a muted recovery, given the longer-term ramifications of the energy shortage and production halts. 

With the revised earnings (Table 1), valuations are now less attractive with an upside potential of just 18.3% as of 16 Sep 2022, with closing price of EUR 408.20. Applying our designated fair P/E ratio of 16.5X for the index, we project a target price of EUR 483 for the STOXX Europe 600 by end-2024. 

Table 1: Lowering earnings estimates on the back of a weakening economy

Without any signs of improvement, the outlook for Europe has deteriorated. Inflation and supply disruption looks to stay, with economic policies turning less supportive. And with the Russia-Ukraine war heading towards a stalemate, Europe’s energy crisis remains a problem.

Considering these factors, we have decided to downgrade European equities from a rating of 3 Stars “Attractive” to 2.5 stars “Neutral”. 

Table 2: Recommended Products

Figure 9: STOXX Europe 600 Price Performance and 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.