Dorval Asset Management’s macroeconomic & market scenario and exposure rates - 12 december 2022
European business sentiment has quite literally plummeted in 2022 in view of the major shock from the economic war with Russia. In Germany, business sentiment plunged even further than in 2008, which is no mean feat (cf. Chart 1). However, this trend is now a thing of the past, and a number of factors suggest that pessimism has started to ease. The magnitude of the fiscal response (support measures, price caps), the drop in commodities prices and the much reduced likelihood of severe energy shortages during the winter are driving this new trend. The European manufacturing industry’s ability to adapt came as a pleasant surprise to many observers. Additionally, the stock of household savings in the euro area remains very comfortable, thereby lessening the prospects of a sharp decline in consumer spending. The recovery in the automotive sector should also continue to prop up growth, as the industry gradually recovers from the dent from component supply shortages. The OECD’s latest projections are for lackluster but positive growth in consumer spending in the euro area of 0.3% in 2023 (and a 0.5% pick-up for GDP). If the OECD is right, the business climate has no reason to remain at its currently depressed level in Europe.
More despondent than ever due to the war, German business sentiment seems to have hit a low
Index of projections for next six months, Ifo survey
The likely reduction in pessimism in Europe should lift the euro’s value, particularly as it is severely undervalued against the dollar. The euro/dollar difference in terms of purchasing power value reached -30% in October according to the OECD, although this has reduced slightly over recent weeks. The euro is logically set to remain undervalued given the terms of trade shock set off by the energy crisis. However, the extent of this undervaluation should decrease, particularly with the interest rate differential between the two areas likely to narrow in 2023 as a result of the near-zero difference in core inflation between the euro area and the US.
Euro displays record discount to dollar
_Purchasing power parity (OECD calculation) / Eur/USD
Over/undervaluation of euro in %_
On the equity markets, showings from European small-caps also reflected the discount built up in Europe in 2022. Small-caps indices underperformed very severely in 2022 for multiple reasons, including for example the high weighting of the real estate sector that has already shed more than 30% of its stock-market value, and a very negative performance from the healthcare sector, which plummeted 42%, vs. a 12% drop for large-caps. Small-caps often have a weaker international dimension, and as such benefited less from the euro’s decline.
However, looking beyond these effects, investors will now most likely require a high liquidity premium in light of increased economic and market risks during 2022. The MSCI Small Cap index – generally pricier in terms of P/E than the Large Cap index, partly due to stronger medium-term growth prospects – shed its valuation gap (cf. chart 3). If we look at median valuations for the small-cap universe rather than the index, we can observe a hefty discount, displaying a median P/E of 11.9x at December 9, 2022, vs. 14.4x for the large- and mid-cap universe.
Relative valuation for small-caps has plunged
Forward P/E for MSCI Small Cap and Large Cap (source Bloomberg)
_MSCI EMU Small Cap / MSCI EMU Large Cap
Relative P/E MSCI Small vs. Large Cap_
In light of this clear discount and given that the European outlook could turn out to be better than expected, we believe that European small-caps should recover some of their appeal as part of asset allocation strategies over the months ahead. Based on our analysis of the euro’s undervaluation, we continue to hedge against exchange rate risk in our international portfolios.