Global investment portfolios mitigate risk and capture opportunities. This is largely achieved through regional weightings. The global economy is split broadly across three regions, led by the US, China, and the Eurozone. The US is slowing down but a recession is unlikely due to substantial savings and robust company as well as bank balance sheets. China will struggle to meet its official growth targets and the impact of slower growth will reverberate across the Asia-Pacific region. Most at risk over the coming two years, is the eurozone, due to its proximity to the war in Ukraine, its dependence on Russian energy, political instability in Italy and its potential to spill-over into another regional sovereign debt crisis. What does all this mean for investors?

European economic data surveys indicate a sharp loss in momentum, and these were compiled before the resignation of Italy’s prime minister, Mario Draghi, and the ECB’s bigger than expected interest rate hike. The S&P Global composite purchasing managers index, measuring both manufacturing and service sectors, fell between June and July from 52.0 to 49.4, below the critical 50-threshold that signals contraction. The reading is at its lowest since January 2021. Chris Williamson, the survey’s chief business economist said “The eurozone economy looks set to contract in the third quarter as business activity slipped into decline in July and forward-looking indicators hint at worse to come in the months ahead.” The European Commission’s consumer confidence measure continued dropping in July, falling from -23.6 to -27 below its previous low reached at the start of the Covid pandemic.

At its July policy meeting the ECB confounded expectations for a 25 basis-point rate hike, instead lifting the key deposit rate from -0.5% to 0%, ending 8 years of negative interest rates. Interest rate futures project the deposit rate will be 1% by year-end and 1.5% next year. The urgency to raise rates is being fed by surging inflation, which hit a year-on-year peak of 8.6% in June. In return for acquiescing to a higher-than-expected rate hike, the inflation hawks granted the ECB a new tool to fight the risk of eurozone fragmentation. In 2012, the ECB adopted an unlimited bond buying programme, called Outright Monetary Transactions (OMT) to shield the Mediterranean countries from rising sovereign bond yields, which translate into higher borrowing costs. The eurozone sovereign debt crisis, which threatened to tear the region apart has come back to haunt the markets. Italy’s 10-year debt spread over German debt has increased to over 2.3% its highest in three years and close to the critical 2.5% level. ECB president Christine Lagarde has launched the Transmission Protection Instrument (TPI). Its purpose is to buy sovereign and private sector debt from eurozone countries that are being unfairly punished by the markets. Purchases can be made in unlimited quantities if necessary.

The risk of eurozone fragmentation has increased sharply since the resignation of Italy’s prime minister Mario Draghi. While in power he successfully pushed through structural reforms, qualifying Italy for a €200 billion handout from the EU’s post-pandemic recovery fund. Under a new more populist prime minister, possibly elected in September, it will be doubtful whether Italy continues to qualify for the handout, in which case, coupled with its 150% debt to GDP ratio, the country may not qualify for TPI support either. The result is a potentially big selloff in Italian bonds and a repeat eurozone sovereign debt crisis. The Italian-German 10-year government bond spread has crept up to 2.38%. This debt crisis would occur with inflation around 8.6% rather than 0% as it was in 2012.

Russia has switched the Nord Stream 1 pipeline back on following maintenance work. The immediate scare of a full gas embargo has lifted, but the temporary outage has left lasting scars. Markets fear that Russia will use gas as a geopolitical tool in the future. Gas prices for forward delivery in July 2023 and 2024 remain at record highs, at €134 and €82 per megawatt hour, well above the average for the past decade of €40. Over 40% of the EU’s gas imports come from Russia. Deutsche Bank estimates Germany, which relies on Russia for over half of its gas imports could suffer a 5-6% pullback in GDP in 2023 if Russia launches a full gas embargo. Italy is a country most at risk due to its dependence on gas fired electricity. Fitch credit rating agency warned that gas rationing for industrial users could cut eurozone GDP by 1-2% in 2023, with a knock-on effect across supply chains. A complete loss of Russian gas could cut eurozone GDP by up to 2-4%, a calculation which excludes the impact on household spending and the impact on business sentiment.

At face value, Europe currently appears to be the least appealing region for investment. But even a bad story can make for a good investment at the right price. European shares are trading at record discounts to the US market, although this phenomenon has been evident for at least a decade. Relative to their own long-term averages, European shares are also very cheap, but they have been cheaper in the past, in the aftermath of the 2008/09 global financial crisis and during the 2011/12 eurozone sovereign debt crisis. Nonetheless, it’s a market worth watching closely as a new investment opportunity may be just around the corner. Valuations are getting attractive. For the EU as a whole, the historic PE ratio is at 12.5x compared with the long-term average of 15.5x and the price-to-book ratio is 1.43 versus the long-term average of 1.77. Germany’s valuations are even more compelling, with a PE and price to book of 10.4x and 1.43 versus long-term averages of 16.0x and 1.80. Italy’s comparisons are 9.6x versus 17.1x on its PE ratio and 1.16 versus 1.55 on its price-to-book.

Although valuations are already cheap, there is further downside to Europe’s equity markets. Bear markets tend to have two down-legs. The first usually occurs ahead of a recession and while earnings are still growing the market de-rates via a compression in PE multiples, due to the impact of rising interest rates and a deteriorating economic outlook. In the second down-leg, equities pull back due to a decline in earnings as recessionary conditions start to bite. In this phase, the market will drop even if the PE remains steady. The market could fall in line with the earnings decline but the PE multiple could be shaken down at the same time to its record lows, especially if the war in Ukraine persists, Russia weaponises its gas supply, inflation remains stubbornly high, or the ECB lifts its interest rate too high. It is often said that policy tightening continues until something breaks. Perhaps a renewed eurozone sovereign debt crisis will be that “break”. Please contact one of OAM’s wealth managers for advice on European investments and our privately managed global investment portfolios.