Europe – Spring has Arrived

By David Ruff, Portfolio Manager

In our January 15th commentary, we highlighted several challenges impacting Europe. Battered by one blow after another over the last several years, the continent never reached full recovery mode after the Covid-19 lockdowns. Unsurprisingly, the continent owns the dubious distinction of being the biggest drag on global growth. However, like new buds in springtime, the continent appears to be thawing after an extended economic winter and should blossom in the near term. We look for the region to produce the biggest positive delta to global economic performance entering into the second half of 2024 and early 2025. The more positive European outlook stems primarily from domestic factors, not trade, and, we’ve made corresponding adjustments to our International and global portfolios to reflect this view.

To be fair, with the exception of Europe’s 2022 drought, the worst in five centuries, which crippled river transport of crucial commodities, many of European economic struggles resulted from shocks affecting the globe, not just Europe. That said, Europe felt an amplified impact. For instance, China-engendered supply-chain logjams prevented a rapid recovery in several European key industries, such as vehicles; and the resulting efforts by companies to build up inventories laid the groundwork for a 2023 downturn, as disappointing sales led companies to right-size their bloated stock levels. This resulted in reduced production relative to sales last year, triggering a late 2023 mini recession. Additionally, Europe suffered most from elevated energy costs due to Russia’s 2022 brutal invasion of Ukraine and the early 2024 Houthi attacks on transiting Red Sea ships increased import costs. Finally, China’s anemic economy hurts Europe’s export engine, especially Germany’s. Understandably, consumer confidence and spend suffered from the seemingly endless list of shocks that conspired to prevent Europe’s economy from achieving its potential. 

Looking forward, some may question our optimism considering the ongoing Ukrainian War and China’s continued struggles limiting Europe’s export growth potential. However, we’d like to point out that the primary reason for stagnation, Putin’s energy shock, has ended. Energy import costs skyrocketed to €587 billion shortly after the War, accounting for nearly 5% of Eurozone GDP, up from €226 billion (1.8% of GDP) before the war. But the continent has adjusted through conservation, alternative sourcing of energy supplies, and transfers of energy-intensive industries to the US, the resultant energy bill fell, approximately, back to pre-War levels. Europe greatly increased its LNG and energy sourcing from Norway, the US, Qatar, Saudi Arabia, and United Emirates. The continent no longer relies on Russia. Note, we’re just starting to see these lower wholesale energy costs get passed through to consumers and companies, significantly easing the burden on household budgets, and boosting company profits. Interestingly, Germany, Europe’s most important economy that normally leads the continent in upswings, has been a relative laggard. We look for this to continue. For one, a significant proportion of Germany’s energy-intensive industries, including chemicals, ceramics, and aluminum moved to the US. These industries will not be returning. Second, Germany continues to run a relatively tight fiscal policy compared to the looser policies of other European countries, such as the southern countries of Greece, Portugal, and Spain. This won’t change soon, as Germany’s constitution requires the so-called debt brake, limiting its ability to deficit spend. Contributing to the fiscal drag since 2019 has been policymakers’ complacency about the business environment, as they have generally favored populist spending measures and greater defense outlays. This leaves little room for fiscal spend to boost the economy. Importantly, the uncertainty of where Germany will cut budget expenditures to fund fiscal stimulus, potentially punishing certain industries, while eroding business confidence, a critical component for investment. Unfortunately, there appears to be little chance for this to change until after elections in the autumn of 2025. Thus, we believe Germany will recover, but unlike past recoveries, Germany will not be leading the continent.

China remains a headwind, but it’s fading. China no longer enjoys the moniker of global economic growth engine, and in our opinion, inefficient capital allocation ensures future economic underperformance relative to the country’s potential. Damage from over investment in high-end residential housing lingers, and policy makers apparently learned little from the experience, as they are now generating over capacity in semiconductor production. Inefficient capital allocation means any achieved growth comes at too high of a cost. Either, the overcapacity leads to a vicious industry downturn or geopolitical problems, if China tries to export its excess supply. Witness the increased tensions surrounding China’s EV exports, as efforts to gain global market share resulted in US and possibly European retaliatory, protectionist policies. Also, as we’ve written before, the Chinese population distrusts the government due to the extended Covid lockdowns. The falloff in spending continues as consumers must rebuild savings, since China has little in the way of a welfare safety net. China’s problems and lack of imports saw global trade slump for the first time in 2023. That said, this headwind appears to be fading with 2024 trade recovering. We highlight the lower importance of China to Europe, as intra-continental European trade flows increase. For example, Total German exports to four eastern European countries – Poland, Hungary, Czech Republic, and Slovakia – now exceed exports to China by two to one. Also, Eurozone trade with the UK, hurt after Brexit, appears to be on the upswing after settling on new trade terms. Finally, Europe’s exports to Russia collapsed to de minimis amounts and no longer represent a headwind. External demand will not drive Europe’s recovery, but will be much less of a headwind compared to 2023.

A major impetus for Europe’s improving economy lies in the ending inventory correction. We’ve noticed this in the broader data and also in our discussions with several of our European companies. Except in Germany, overall Eurozone inventory recently returned to 2018 levels. This means production can normalize, matching sales, and boosting economic growth. Another positive, European inflation appears to be stabilizing, already under 2.5%. Some economists believe it could overshoot to the downside, briefly falling under 2% due to the energy cost adjustment mentioned above. This gives the European Central Bank room to lower interest rates sooner. This suggests European 10-year interest rates may find an equilibrium near 3.0% versus the US, where challenging labor costs, aggressive fiscal spend, and service cost inflation means long-term interest rates probably settle at higher levels, possibly 4.5% to 5.0%. Bottom line, with 2% inflation and real disposable income growing 4.5%, Europe enjoys enhanced consumer purchasing power.

Given our optimism regarding Europe’s likely domestic-led recovery, we’ve selectively added some European cyclical exposure. This includes Brenntag, a leader in the highly fragmented chemical distribution industry. We look for Brenntag to leverage its position to bring about consolidation from the many family-owned businesses in the industry, and we like the management’s new focus on greater operational efficiency. This should provide a re-rating or higher valuation for the shares. The business model reflects greater reliance on specialty chemicals and value-added services, such as producing tailored chemical formulations for customers. These capabilities provide better profitability compared to the commodity chemical distribution model representative of most of the industry. In summary, although it’s important to be prudent and not skew investments towards any one economic scenario, we’re much more positive on Europe than we’ve been for a long time. The continent will receive modest external help through trade this year, but domestic support will drive the economy. Yes, we believe it’s truly springtime in Europe.

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