iCapital Market Pulse: The Summer of Europe

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Despite entering the year in a technical recession, growth for the region in 2024 has been more resilient than expected. The headwinds the European consumer dealt with in the last few years now appear to be turning into tailwinds, as energy prices and interest rates have fallen from their 2022 and 2023 highs. This has not only supported the European consumer, but it has also led to an improvement in business confidence. This backdrop has translated to better-than-expected earnings, which should continue through the remainder of the year given the strength in earnings revisions. With European equities trading at a new record high, they can likely sustain their recent outperformance, especially as we head into the summer travel and tourism season, which should further support consumption and service activity for the region.
 

Brighter growth prospects as we exit the downturn

Even despite sluggish GDP growth in the first quarter, it marked the end of the brief downturn the region experienced in the second half of 2023. Economists expect growth to pick up into next year as we have seen positive revision to year-over-year (YoY) GDP growth estimates for the remaining quarters this year.

Economic growth in the Eurozone has largely been supported by service activity. While the Europe service PMI was unchanged in early May, it remained at its highest level since May 2023 (Exhibit 1). However, the forward-looking components – such as new orders, which made a 13-month high – would suggest that the PMI could continue to rise over the coming months. Service level activity should also be supported by the summer travel and tourism season. There are a number of music tours set to take place in Europe this summer, specifically the Swift Era tours, which kicked off its European leg in early May. Some economists believe that the Swift Era tour could have a broader impact on the European economy compared to the U.S., which helped support the strong GDP growth in the third quarter last year.¹ Indeed, recent card spending data showed a 22% YoY increase in point-of-sales spending in Paris during the Eras tour – similar to the boost we saw in the U.S.²

While service level activity has remained healthy, the manufacturing industry remains in a contraction. But there are signs that the industry could be in the early stages of a recovery, as manufacturing activity troughed for the region. Indeed, the Eurozone manufacturing PMI reached its highest level since February 2023 and is now almost 5 points higher than its low of 42.7 in June 2023.³ Similar to the service PMI, we have seen quite an improvement in the forward-looking components for the manufacturing PMI – highlighted by new orders reaching their best level in two years.

The European economy finds relief from lower inflation and rates

The disinflationary trend in Europe appears to be in a better place than the United States. Indeed, after peaking in October 2022 at 10.6% YoY, Eurozone inflation has fallen to 2.4% YoY.⁴ While yields have steadily trended higher throughout the year, the 10-year German Bund also remains below the 3% high it made in October 2023. Lower inflation and thereby lower rates should help ease financial conditions in Europe. In fact, the Goldman Sachs Financial Conditions Index is now 60 basis points easier than it was in October of last year.⁵ But, there are other examples of how financial conditions have eased across the region.

First, we have seen lending standards become less restrictive for the region. In the latest bank lending survey, the tightening of credit standards for both firms and households fell to levels seen in 2021.⁶

Second, the European consumer is more sensitive to the move in interest rates. Indeed, 53% of mortgages are floating rate for the average European country.⁷ With the European Central Bank (ECB) expected to continue to cut rates this year, this should help put downward pressure on consumer borrowing costs, specifically regarding mortgages, as seen in Exhibit 2.

Lower inflation and lower rates should also support real disposable income growth for the European consumer, which is expected to rise by 2.5% Q4/Q4 in 2024.⁸ Nominal wage growth has also remained healthy, as it recently rose by 4.7% in the first quarter this year.⁹ However, this increase in disposable income has not fully fed through to consumption as the savings rate has also increased. Unlike the U.S., the savings rate in Europe remains above pre-COVID levels. With the European consumer not exhausting all their excess savings, this could provide support to consumption at some point down the road.

But easier financial conditions have not just supported the consumer, they have also boosted business sentiment. Indeed, in the latest PMI data, business confidence across both manufacturing and service industries jumped to the highest level in 27 months.¹⁰ The uptick in business confidence is particularly evident in Germany where business confidence has increased to the highest level in 12-26 months, as seen with the ZEW (See Exhibit 3) and IFO Business expectation surveys.

Here come the rate cuts

Policy makers have greater confidence on the trajectory of inflation in Europe, and thus began their rate cutting cycle this week. However, it does not seem like this will be a one and done rate cut, as several ECB speakers have acknowledged how we could see a few cuts this year. While markets are priced for a second cut coming at the ECB’s September meeting, recent commentary from the French Central Bank president (Francois Villeroy de Galhau) suggested that the ECB could cut rates again at their July meeting.¹¹ However, the path of rate cuts later this year will ultimately be determined by the path of inflation, specifically the path of service inflation, and negotiated wages agreements.

This will likely be a unique rate cutting cycle in Europe, as historically the ECB has lagged policy actions from the Fed. Instead, this cycle, the ECB appears to be a leader as they have started their rate cutting cycle ahead of the Fed and are expected to cut rates more than the Fed this year.

The earnings recovery is underway

Despite earnings declining by 5% for the quarter, aggregate earnings positively surprised by 8% — the best reading since the first quarter of 2023.¹² Even with the continued declines in earnings growth, it does appear that earnings likely troughed in Europe last quarter. We think earnings growth in the region will be supported by the large positive revisions we have seen. Indeed, looking at the earnings revisions index for European equities, it is at its highest level in over a year.¹³ In addition, if you look at the one-month change in earnings revisions, Europe is largely outpacing other developed peers.¹⁴ Revisions have been led by financials, pharmaceuticals, semiconductors, and utilities. Therefore, consensus earnings growth forecasts of 6% in 2024 and 11% in 2025 seem achievable.¹⁵

We believe European equity outperformance can continue

Over the last three months, European equities have outperformed the S&P 500 in both U.S. Dollar (USD) and local currency terms. We believe this outperformance can continue given the resilience of the economy and the tailwinds that are starting to support the consumer. In addition, we think service activity should be supported by the summer travel and tourism season that is now upon us.

While the macro environment is turning more favorable for the region, we think the earnings recovery should provide another avenue of support for European equities. As earnings revisions are being led by financials, pharmaceuticals and semiconductors, this could favor countries such as Germany and Switzerland, which have large exposures to these sectors.

With the ECB having cut rates, this could provide an additional tailwind to European equities. Indeed, we find that when the ECB cuts rates, European equity returns tend to perform better than historical averages in the year following every ECB rate cut since 2000.¹⁶

While there was much focus on the U.S. exceptionalism theme earlier this year, Europe’s recent outperformance is a helpful reminder that it is important for portfolios to be geographically diversified. If investors are underexposed to Europe as a region, this could be an opportune time to start to increase their exposure to the region.