Can the strong performance of European equities continue? - 3 april 2023

Has the 2011–2012 eurozone debt crisis actually helped the situation? The regulatory measures taken during and after the crisis as part of the EU's banking union project have in any case significantly strengthened the resilience of the European banking system. Tier 1 capital ratios have risen year after year over the past decade, reaching an average of 15% in the eurozone (cf. chart 1). It should be noted that small banks are particularly well capitalised, with a Tier 1 ratio of 17%. Banks are also well capitalised in the United States, however, regulations were relaxed in 2018, especially for small regional banks. The profits of European banks are being further boosted by the end of negative interest rates, a policy that was not pursued in the United States. This does not mean that eurozone banks will be immune to the economic and financial problems that rising rates will cause (real estate, private equity, LBOs etc.), but the systemic risks that the eurozone often experienced during the 2010s seem to be better controlled

After the relief of a winter without energy shortages and, for the time being, the lack of banking contagion, the question now is what level of interest rates the eurozone can sustain. Markets expect the ECB to raise its deposit rate from the current 3% to more than 3.5% in the autumn, before falling slightly in 2024. Even if damage is to be expected after a decade of negative rates, this scenario does not seem to be sowing the seeds for a serious recession. However, the process of disinflation will have to be fairly quick. Unsurprisingly, the figures for March indicate that base effects and lower energy prices are beginning to have a significant impact on year-on-year inflation statistics (6.9% in the eurozone, down from 8.5% in February). If energy is not taken into account, however, inflation continues to accelerate (cf. chart 2). In a few months, disinflation should also occur in the food sector, where high inflation stems partly from the rise in energy costs in 2022. In the manufactured goods sector, supply chains returning to normal should also reduce inflationary pressures, as in the United States.

If the second-round effects of both the post-COVID period and the war in Ukraine are reversed, services inflation, which is often linked to wage increases, may struggle to drop this year. The eurozone unemployment rate is indeed at a record low and there are significant pressures regarding wages. The ECB is therefore not about to lower interest rates.
Finally, disinflation will be accompanied by questions regarding corporate profits. A recent ECB study suggests that more than half of the inflation in the second half of 2022 came from profits, rather than wages (cf. chart 3). This rise in margins – partly caused by a deadweight loss allowing pricing power, which for a long time has been limited, to increase – seems difficult to sustain. Will disinflation be accompanied by reduced margins or will other factors (including China’s recovery and a recovery in consumption) help keep them high?

All in all, we believe the current phase of the cycle is favourable to European equities, due to banking resilience, increased profits, disinflation reducing pressure on interest rates and purchasing power, and reasonable valuations. In the long run, risks lie mainly with sectors that are most sensitive to credit tightening and questions regarding the outlook for company margins (disinflation, rising value of the euro).
In our global funds, we are maintaining exposure to equities close to our benchmarks. Credit channel tightening has led us to create an equally weighted basket of around 50 defensive securities that is highly geographically diverse but focused on three sectors: health, non-discretionary consumption and utilities.

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