Is ‘Make Europe Great Again’ replacing US exceptionalism?

Is the correction in US equities over yet?

Back in January, I had estimated the correction potential for the S&P 500 at around 20%, taking into account the gap between current valuations and their ten-year average. Consequently, there still remains some theoretical downside potential. This could increase even further if earnings expectations were to be revised downwards, which would make valuation multiples based on forward earnings look more expensive today.

In fact, a decline in earnings expectations in the US appears to be a distinct possibility in my view. Some of the latest economic data has recently been disappointing. US consumption, of all things, seems to be cooling down at the moment. Latest retail sales were well below expectations, consumer confidence is declining, and consumer spending has fallen contrary to expectations. At the same time, inflation expectations have risen in anticipation of tariffs imposed by Donald Trump. All in all, the current situation does not appear to be particularly favourable for US consumption. Since consumption accounts for almost 70% of US GDP, market participants are likely to pay more attention to consumer-oriented economic data in the coming weeks and months.

MAGA becomes MEGA (“Make Europe Great Again”)

In Europe, however, the situation looks entirely different. Here, a sense of euphoria seems to be spreading. This is largely due to the German infrastructure package initially announced and now approved by the government, worth 500 billion euros, and the relaxation of the debt brake for defence spending. Additionally, the EU member states have recently agreed an 800 billion euro package for the rearmament of Europe. These substantial investment programmes have the potential to provide the long-awaited growth impetus in Europe and are likely to have a significant effect on broad parts of the European industry.

We believe that many European companies stand to benefit from the investment boom that is expected. While the focus has recently been on defence companies, we believe that many other industry-related companies could also benefit from the upcoming investment programmes. Furthermore, the 100 billion euros allocated by Germany for climate protection measures in its infrastructure package is poised to generate new growth opportunities for a variety of companies. The banking sector is also poised to benefit from the surge in demand for credit that can be expected to follow an economic upturn driven by capital investment.

While there has been a massive movement of capital from Europe to the US in recent years, some of this capital may return to Europe after the latest events, provided that the narrative of an upswing in the European economy becomes firmly established. If only a portion of this capital would flow in the opposite direction, it may provide some support to the European equity market.

From a valuation perspective, the European equity market still does not appear particularly expensive, despite recent gains. The forward P/E of the MSCI Europe is now almost exactly in line with the average of the past ten years. Should earnings expectations for European companies increase in the coming weeks due to the rising optimism, European equities may still offer relative value based on current conditions.

A comparison of the valuation of the US equity market with that of Europe over the last 20 years is quite interesting. It is evident that US equities have consistently traded at a substantial valuation premium compared to Europe, averaging almost 25% over that period. The substantial increase in the valuation premium in recent years, which reached a peak of 69% in December of last year, is also striking. Since then, however, the premium has fallen dramatically to around 42%. Nevertheless, there is still sufficient room for a further normalisation of the valuation discrepancy.

There could be a lot of opportunities in Europe, especially among value stocks

Recent trends appear to favour Europe, particularly in the value part of the market. This is due to the fact that industrial-related companies are widely regarded as the primary beneficiaries of the anticipated investments in infrastructure and defence. In our European value strategy we hold companies such as Arcelor Mittal, Bilfinger, Wienerberger and Daimler Trucks. There are also still many undervalued companies in the banking sector with forward P/E ratios well below 10x, despite recent price gains. Bank holdings in our value strategy includes names such as Commerzbank, Caixabank, Bank of Ireland and BBVA, among others.

Investment programmes in Europe are not without risk

While the programmes are expected to stimulate the sluggish economy, they could also result in an upward trend in European bond yields. The announcement of the €500 billion infrastructure package alone caused the yields on ten-year German government bonds to rise, and the yields on other euro government bonds with them. Roughly half of this rise can be attributed to higher inflation expectations, with infrastructure and defence spending being viewed as inflationary. The other half is likely to be due to an increased perception of risk. The precipitous rise in yields, which was observed even for Germany, despite its moderate debt-to-GDP ratio of 63%, serves as a harbinger for the potential consequences that could befall countries with significantly higher public debt ratios, such as Italy (135%), France (111%), and Spain (108%), should they embark on similar fiscal initiatives.

Since rising yields exert additional pressure on the budget situation of EU countries through increased interest costs, they potentially could curb investment efforts overall. At the same time, rising yield levels tend to have a negative impact on equity valuations. Therefore, equity investors should keep an eye on the direction of government bond yields.