Thoughts from the Road: Down, But Definitely Not Out

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When Aidan, Bola, and I penned our last Thoughts from the Road note on Europe in early August (see Keeping Perspectives), we indicated that sentiment was likely too bearish relative to fundamentals. This backdrop was an opportunity, we believed. Since then, European equities have outpaced those in the U.S., with the Eurostoxx up more than double the S&P 500 so far in 2023 (12% versus 5% as of January 26th).

Another trip in late January 2023 to Europe, which we detail in this piece, has only reinforced our view that there is actually still more running room ahead, especially within private markets. Key to our thinking is that the bear case on the European macro will not play out as badly as many prognosticators have been foreshadowing. While not immune to the recent war-induced commodity shock, economic growth in Europe is holding up better. In fact, after performing our most recent macro deep dive, we are raising, not lowering, our GDP forecast for the Euro Area. At the same time, we are lowering our inflation forecast.

Importantly, the better-than-expected growth and lower than anticipated inflation we are seeing is occurring at a time when allocations to Europe are at record lows across Public Equities, Private Equity, and Credit. As such, any additional spark of good news will further fan the flames of relative outperformance, a surprising reality we believe is catching many underweight global allocators off guard.

Another important variable to consider is the potential further strengthening of the euro relative to the U.S. dollar, which is one of our key calls for 2023 (see Outlook for 2023: Keep it Simple). Ultimately, we think that there is an exchange rate tailwind unfolding in Europe that will draw global investors off the sidelines, many of whom will be forced to rebalance their portfolios.

Finally (and probably most importantly), there are some very resilient and compelling investment themes unfolding in Europe, including fertility, automation/digitalization, energy efficiency and climate that are short capital. To this end, we think that global allocators should be allocating capital to these mega trends, despite what we agree is one of the more complex macro stories out there these days.

So, what did we learn along the way and what changes are we making to our outlook?

  • We are revising up our Euro Area GDP. Our European macro team, led by Aidan Corcoran, is revising up estimates for Euro Area Real GDP growth in 2023 to +0.4% from -0.2%. The primary driver of this change is the unseasonably mild start to the winter in 2022-2023, which is leading to a less severe energy shortage. Our forecast for Euro Area Real GDP growth in 2024 is now +1.4%, down from our previous estimate of +1.6%, due to the tougher comparisons after we upgrade 2023 growth, as well as the lagged effect of tighter monetary policy. See Exhibit 3 for our base, bear, and bull case scenario analyses.
  • At the same time, we are lowering our inflation forecasts. While core inflation including sticky labor costs remains a headwind to corporate profit margins, we are trimming our inflation forecasts. A key catalyst for this reduction is the price of natural gas. Indeed, in oil equivalent terms, today’s natural gas prices in Europe are now around $105 per barrel, compared to an earlier peak of over $500 in 2022. This massive decline is capping headline inflation risks. As such, we are cutting our expected inflation expectations for 2023 from 6.3% to 5.9% and for 2024 from 2.6% to 2.3%.
  • Consumer health is better than expected. Consumers saved close to an extra trillion euros in the Eurozone alone during the 2020-2021 period. Employees are also seeing good nominal wage growth, partly offsetting the increased costs from energy, food and mortgages. As a result, key parts of the economy, including the shift from goods to services-based experiences, are performing strongly in 2023, a trend we look to continue for quite some time.
  • The U.K. game plan feels more sensible. London was one of our stops, and what a difference a few months have made. The Sunak government has successfully steadied the ship following the U.K. pension fund liquidity crisis of last September/October. The fiscal plan feels better, there are some good growth initiatives, and the extreme bear case on inflation is abating. On the other hand, the low-end consumer continues to face challenges, real incomes are being hit hard, and continued fiscal retrenchment will be necessary over the coming years.
  • From a thematic perspective, many of our continuing themes such as Automation/Digitalization, the Energy Transition, and the Resiliency of Everything are gaining momentum and are only strengthened by the current environment.


The Euro Area Current Account Is Now Back Into a Surplus, as the Terms of Trade Shock Unwinds

Graph of the Euro Area Current Account since 2009
Data as at November 30, 2022. Source: Eurostat.

From a thematic perspective, many of our continuing themes such as Automation/Digitalization, the Energy Transition, and the Resiliency of Everything are gaining momentum and are only strengthened by the current environment.


Europe Has Been Consistently Surprising Consensus Since November Last Year, Whereas the U.S. Has Been In-Line

Graph Comparing Europe and US
Data as at January 23, 2023. Source: Bloomberg.

Looking at the big picture, we reiterate our mantra to Keep It Simple in 2023. Many parts of Credit in Europe appear attractive, especially given banks have pulled back on lending. Consistent with this view, 2023 should be a good vintage for Real Estate Credit, Direct Lending, and even parts of Mezzanine. We also like what we hear around Infrastructure in Europe, especially as it relates to fiber build-outs (an ongoing theme we have been pursuing), as well as the energy transition. Finally, we continue to pound the table that Private Equity in Europe in many instances is a much more effective way to see value creation in the region than Public Equities. In particular, we are excited about the potential for public to private transactions and corporate carve-outs.