Head of Equity Strategy
Summary: Economic growth in Europe is the lowest since the years 2011-2013, if the early months of the pandemic are excluded, and a new energy crisis this winter cannot be ruled out. With Germany already in a recession and its industry on its knees for how long can investors ignore the bad signs? Earnings growth in Europe has been negative for three quarters and confirmed in the Q2 earnings season. While growth prospects and Germany returning as the "sick man of Europe" equity valuations have hit their biggest discount to US equities since 2006 reflecting that investors have never been more negative on Europe vs US.
European economic growth went sharply into contraction in September 2022 as the negative forces of high commodity prices and especially penalizing energy prices lowered consumer confidence and made industrial production unviable. Through an extraordinary lucky winter with above average temperatures Europe got through its energy crisis. With commodity prices easing in 2023 and the US consumer hanging on to strong consumption economic activity in Europe rebounded in January and February before sliding into severe negative territory by June. Last month offered a small improvement in economic activity but the estimated quarterly GDP growth was still -0.56% (see chart) and the 12-month moving average has declined to -0.3% which is the lowest activity levels, excluding the early months of the pandemic, since the euro crisis years of 2011-2013.
The lower economic growth in Europe has also impacted earnings growth with 12-month trailing EBITDA peaking in Q3 2022 and declining ever since including in Q2 2023. This development combined with excitement over AI technology, which benefits US technology stocks, have pushed European equities to their biggest valuation discount to US equities since January 2006. Investors are pricing European equities at a 35% discount relative to expectations over the next 12 months. In other words, US equities are priced for perfection against Europe and thus the contrarian investor would naturally tend to overweight Europe vs US despite the growth issues in Europe.
One thing is the relative game against US equities, but another reality is the absolute valuation level. European equities are valued at 8.7x on the 12-month forward EV/EBITDA multiple which is roughly 24% above the valuation levels investors were willing to pay for European equities back in 2011-2013 when the continent was dealing with a currency and debt crisis when Europe was seeing the same low economic activity levels as of today. The believer in rational and efficient markets would say that the difference could be explained by the fact, that in 2011-2013 there was a real euro breakup risk while today growth is impacted temporarily factors such as higher energy prices related to the war in Ukraine. While investors are offered value in Europe it comes with risks. The continent is fast approaching its second anniversary of the war in Ukraine and Germany’s structural growth issues could hold back the continent unless Berlin wakes up to the new geopolitical reality of the fragmentation game. The energy crisis as function of the war in Ukraine and cutting energy trade with Russia, has not been solved and could come back and haunt Europe for a couple more years. Europe’s lack of fast-growing technology companies is another risk (the risk of low earnings growth in an age of digitalization).
Germany was often by the foreign press labelled the “sick man of Europe” during the 1990s and up until 2005 as structurally higher unemployment rate and low growth were part of the post-unification years. The expression has recently come back to live as the German economy has recorded three straight quarters of negative or flat GDP growth q/q with its industry complaining about bad industrial and energy policies.
China’s integration into the world economy through its adoption into the WTO in 2001 was a game changer for Germany. China’s growth in the subsequent years was high and its share of global trade skyrocketed as companies in the US and Europe were rushing to “outsource” its manufacturing to China as cheap labour and formidable logistics infrastructure made it a perfect platform for becoming the “world’s factory”. In building the “world’s factory” China needed a lot of advanced machines and knowledge which Germany’s industry provided jumping on the Chinese growth journey.
Angela Merkel, the Chancellor of Germany during 2005-2021, had for years an impeccable reputation, but her years as Chancellor overlapped with the rise of China providing tailwinds for the German economy. One could be cynical saying that Merkel’s apparent success was due to China’s policies. One thing was not luck, and that was Merkel’s deliberate integration with the Russian economy in the form of cheap energy creating an industrial competitiveness against other European states. With the “Energiewende” policy eventually leading to the complete closure of all nuclear power plants and more intermittent electricity production from wind and solar, Merkel happened to create the highest beta to the previous world order and globalisation.
It follows naturally from this that a fragmentation game in which the US and Europe are slowly disentangling itself from production and trade with China and Russia will lead to Germany being the biggest loser. With ending of China’s last growth stage and Russia’s disintegration from Europe, the entire economic model of Germany has changed for the worse. The structural issues might not be as bad as during the “sick man of Europe” days of the 1990s, but the failure of building a digital economy and cluster of powerful technology companies combined with the car industry ongoing its biggest competitive change in 70 years are exposing the Germany economy to key risks.
A weak Germany is obviously bad for European growth and investors betting on European equities should hope for Berlin to wake to the new era of geopolitics realizing that it must dramatically change its economic model and invest heavily into that change.
Siemens Energy shares are down 6.5% today as the energy equipment maker announced that it expects full fiscal year loss of €4.5bn on new charges related to design problems in its newest wind turbines affecting 4% of its installed capacity. While the wind turbine business is unprofitable and undergoing big challenges, the order intake is still looking good and especially in its Grid Technologies segment which saw orders rise 64% y/y in Q3 2023 (ending 30 June). In many ways, Siemens Energy represents Europe. There are some things that are horribly wrong and other parts which are doing really well. With analysts expecting FY24 EBITDA of €2.46bn due to strong growth in its other businesses outside wind turbines the equity valuation is as low as 5.3x on forward EV/EBITDA for a business with overall order growth of 54%. In US equities, investors are willing to pay steep prices for the hope of growth from AI technologies while in Europe investors are dumping companies such as Siemens Energy despite growth and a technology portfolio that is necessary for the energy transition.
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