By Henry H. McVey May 10, 2023
Aidan Corcoran, who heads our European macro effort, and I recently spent time traveling across Europe, with informative stops in Frankfurt and London. If there is one take-away that resonated for us after all of our meetings, it can be summed in the quote often attributed to Mark Twain that the “reports of my death are greatly exaggerated”.
We get it. Europe is never going to be a growth powerhouse, especially given the ECB's single mandate on inflation (not both inflation and growth), its challenging demographic profile, and its geopolitical position in today’s world order. However, it is doing just fine. In fact, it is likely doing better than most investors think, and therein lies the opportunity, especially in the private markets. Just consider that over the past six years, Europe has been the best performing region on the KKR balance sheet on a combined basis across all asset classes.
In terms of our main observations, we note the five key takeaways from our trip:
- Europe has stickier inflation than most developed markets; unlike in the U.S., goods inflation has not come down very much. All told, goods inflation was still running at 8.1% in Europe as of March, which is 650 basis points above the U.S (Exhibit 7). Moreover, the broadening out of inflation across the region has kept non-energy industrial goods (i.e., those more isolated from the energy crisis) still running at 6.6%, and unfortunately, we see few signs of a quick return to the ECB’s target of two percent. Meanwhile, rising wages and decent demand for leisure and travel are keeping services inflation running at 5.1%, which compares to 2.7% a year ago and 7.2% in the U.S.
- Given that the ECB’s singular focus is on inflation, Europe will probably need to run the tightest monetary policy this cycle. This backdrop continues to argue for a higher euro relative to the dollar, and it also means that the cost of capital for this region will be higher on a relative basis this tightening cycle than in the past. However, given structurally lower growth, there are limits to how high rates can go, which likely means allocators, especially including insurance companies, will ultimately need to harness the illiquidity premium to generate the returns they need to satisfy their liabilities. Consistent with this view on the ECB’s focus, Aidan and his team remain above consensus on the direction of short rates. Specifically, they are looking for the ECB deposit rate to peak at 3.75% by September 2023, with cuts beginning only in mid-2024 and the depo rate ultimately resting at 2.5%.
- It is not too late to invest behind our KKR theme of ‘experiences over things’ in Europe. Travel and tourism are booming, but we think that ‘revenge spending’ will boost the services share of GDP from below trend to well above trend. Indeed, similar to what happened after World War II and 9/11, consumer spending on travel, dinners, entertainment, etc., will surprise on the upside, despite a lack of real wage growth. Meanwhile, data, towers, and parts of telecoms are still very investible themes.
- Europe is near the top of the pack on two other global mega-investment themes: the energy transition and the security of everything. There are no red versus blue state debates in Europe. Everyone is behind the energy transition, and as such, Europe has emerged as a leader in this area. At the same time, Russia’s invasion of Ukraine has accelerated the ‘security of everything’. Redundancy spending on energy, data, transportation, and security are providing an important buffer during this slowdown. Meaningfully, it is taking the form of both opex and capex this cycle.
- Brexit has led to a different experience for the United Kingdom than in the rest of the Eurozone, as supply-side disruption in several spheres has compounded inflationary pressures despite anemic growth when compared to the rest of Europe. The readjustment of supply chains and increased red tape have kept food inflation high. Also, at the height of the energy crisis, limited gas storage led to greater price volatility. Finally, the structurally tight labor pool (with net migration from Europe falling off) has kept alive the specter of a wage-inflation spiral. All of these factors have tested the relative dovishness of the Bank of England.
Like the U.S., Services Over Goods Is Also the Story in Europe
So, despite a lot of negative investor sentiment, most of what we saw and heard during our trip has reinforced our conviction that the Eurozone will again put up an acceptable GDP growth number in 2023.