Europe’s abating headwinds

Over the past decade, European equity returns have lagged the US. The Euro Stoxx 50 has returned an annualised 4.4% while the S&P 500 has delivered 11.1%. Much of the past decade’s European equity market underperformance has been the result of both structural and cyclical challenges that the European economy has had to contend. Now though, as European shares trade at depressed valuations, and some cyclical woes abate, investors are beginning to take a second look at the region and ask if an opportunity may be developing.

Secular challenges

With GDP growth 27% below the US since 2000, Europe quite clearly has a productivity problem. In fairness, five percentage points of this underperformance is the result of the lower population growth. However, the remainder is the result of weaker GDP per capita growth.

Much of this slower growth can be attributed to widespread underinvestment in European businesses – see Figure 1. An economy that is not adding as much new capital behind its workers will see its productivity trail other nations with higher investment rates. This can be seen in in the bottom panel in Figure 1 where Europe’s low levels of R&D intensity lead to lower productivity than other nations. The absence of significant R&D spend has led to Europe’s information and communication technology (“ICT”) sector materially lagging the US which includes mega cap businesses such as Nvidia, Apple, Amazon, and more.

Figure 1 – Capital expenditure is vital for productivity growth

There are three main causes of Europe’s low levels of investment:

Market fragmentation

The relationships between the governments in Eurozone countries and the European Union’s (“EU”) central institutions are far less integrated than the relationships between the federal and state governments in the US. As a result, the complex, multi-layered regulatory framework that exists puts Europe at a disadvantage to the US.

For example, the IMF estimated that non-tariff barriers across EU nations are equivalent to a 44% ad-valorem tariff on goods. While the barriers between US states approximate a 15% tariff. As a result, European firms struggle to achieve the scale necessary to access large capex programs and fund R&D programmes. This results in the majority of EU firms remaining micro and small firms in stark contrast to the US – see Figure 2.

Figure 2 – Europe’s concentration in small firms which lack economies of scale

Lack of capital market depth

The second reason for the low levels of capex and R&D in Europe is the lack of capital market depth. European banks tend to dominate lending, accounting for 70% of all business loans compared to just 26% in the US. Instead, US businesses typically raise funds through capital markets. By nature, banks cannot diversify risks as efficiently as capital markets, and as a result risk averse European banks require elevated risk premia to fund capital expenditure. Limiting the accessibility of capital to businesses.

In addition, the lack of capital market depth means that banks are unable to securitize their loans by selling the debt on to investors, leading to banks becoming even more conservative – see Figure 3. The lack of capital market unification also means there is a lower prevalence of venture capital available to finance high-risk R&D in the EU relative to the US. With less liquidity and depth, European markets fail to attract the global savings on the same scale as American markets.

Figure 3 – Shallow capital markets mean risk-averse financing

Regulatory burden

The final major problem the EU faces is regulation. Mario Draghi recently highlighted this in his report on European competitiveness, where he discussed the tendency for national governments to impose their own interpretations of the EU’s regulations. Which creates “gold-plated” regulations which contribute to an extremely complicated regulatory landscape making it challenging to deploy capital and weighing on returns.

Cyclical headwinds

In addition to the above-mentioned secular challenge facing Europe, there are several cyclical headwinds that have prevailed since the Global Financial Crisis (“GFC”). Namely, prolonged deleveraging, a weakened banking system, excessive fiscal austerity, and high energy costs. However, unlike the secular challenges described, these issues could soon dissipate.

Deleveraging

In the wake of the GFC and the European Sovereign Debt Crisis, the European private sector has undergone a prolonged deleveraging, which has been a major impediment to growth. For example, as various European consumers cut their debt loads, their consumption fell, and countries like Germany in which 33% of GDP is generated through exports to Europe saw their economy slow significantly – see Figure 4.

Figure 4 – When their European trading partners deleverage, German exports fall

Weakened banking system

Weaker banks compounded Europe’s deleveraging woes. After the GFC, European banks saw their non-performing loans (“NPL”) rising rapidly, with Italian and Spanish NPLs reaching levels as high as 18% in 2015 and 9.4% in 2013, respectively. To add to banks’ woes negative interest rates depressed their net-interest margins and weighed on the sector’s profitability so severely that their ROE’s declined to levels as low as 1% in 2013.

Consequently, bank lending practices became ultra-conservative, and the supply of credit fell. Not only did tighter bank lending standards hinder the ability of firms to fund new projects, but the lack of liquidity also hurt aggregate demand for the products of European businesses.

Fiscal austerity

After the GFC, the governments of countries like Spain, Portugal, Greece, and Italy engaged in aggressive fiscal cuts. Unfortunately, because the private sector was also deleveraging during this period this proved to be ill timed. In such an environment, a government needs to work counter-cyclically and dissave to facilitate the private sector’s efforts to rebuild their balance sheets. As a result of this fiscal misstep, both nominal GDP growth and the private sector’s deleveraging efforts were prolonged.

One of the more extreme examples of fiscal austerity is Germany’s “debt brake”, which constitutionally limits their structural deficit to 0.35% of GDP. Since implementation the “debt brake” has constrained their fiscal flexibility and thus, their ability to respond to economic shocks. It has also led Germany’s public infrastructure spend collapsing to a low of 0.08% of GDP in 2023, which has become a major drag on German growth.

Energy drag

Historically, Europe has operated in a mild energy deficit and thus had to bear higher energy prices than the US. Then in 2022, when the war in Ukraine broke out the deficit became extreme, and European natural gas prices reached record levels as high as €339/MWh. Despite prices declining 83% since then, gas supply remains constrained and electricity prices for industrial users remain 106% higher than those in the US – see Figure 5. This, of course, negatively affects the profitability of Europe’s industrial sector, and has knock on effects on the sectors output, employment figures, and capital expenditure.

Figure 5 – Visualising the energy drag

Dissipating headwinds

While many of Europe’s challenges are not dissipating any time soon, enough are easing that we believe the outlook for the region is improving, especially relative to the US.

For example, the nonfinancial private sector’s debt load has fallen from a peak of 110% of GDP to 95%. Meanwhile corporate financial assets are standing at healthy 264% of GDP. Meaning European balance sheets are strong, and in a position to take advantage of ECB policy easing, which should lead to revived spending.

While the process by banks to improve their balance sheet health over the last decade curtailed credit creation and growth, it has also bore fruit. Today, Eurozone banks boast Tier 1 capital ratios 2.5% higher than their US counterparts. In addition, Eurozone non-performing loans have declined from highs of 6.5% in 2015 to just 1.7% today.

Finally, the ECB’s exit from negative interest rates has led to net interest margins finally rising. Consequently, the ROE of Eurozone banks have recovered to pre-GFC levels and now stand at 13% – see Figure 6. Healthy banks should enable improved availability of financing and in turn a recovery in capital expenditure and productivity.

Figure 6 – European banks have returned to profitability

Investment takeaway

With government and private sector deleveraging ending, robust bank balance sheets, and normalising energy supply, we believe many of the headwinds that have hobbled European growth over the past decade are ebbing. In turn, we believe returns on capital and thus, investment and productivity are set to grow. Especially if Europe begins to deregulate to some degree.

While the near-term dynamics remain uncertain, we believe the 5-to-10-year outlook for European equities has markedly improved. Finally, with valuations at peak pessimism levels we believe just a moderate improvement in European growth could be all that is required for a medium term turn around in equity prices – see Figure 7.

Figure 7 – A long term downwards trend, primed for medium-term mean reversion

If you are interested in finding out more about how cognisance of the macroeconomic backdrop impacts our investment decision making process, connect with Integrity Asset Management and let us help you navigate your investing journey.

For more information on this synopsis or to discuss solutions provided by Integrity Asset Management, please contact us at:

Tel: (021) 671 2112
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E-mail: nic@integrityam.co.za / herman@integrityam.co.za

Source: Bloomberg, 28 February 2025