Portfolio Managers Matt Burdett and Joe Salmond look to Europe where valuations, rapidly falling energy prices and the dollar’s strength create opportunities.
To say Europe has been unpopular with global investors is a dramatic understatement. In calendar year 2022 we’ve seen war return to Europe, political and economic crises in the UK, the possibility of a gas and energy shortage as the continent heads into the winter months, inflation, and an impending recession.
However, the darkest times may also be the best time to look again as attractive investment opportunities begin to emerge. Europe offers exposure to a broad variety of high-quality global companies that provide a path to diversification out of the highly concentrated U.S. market, combined with the potential for an alpha-generating market recovery – all at attractive valuations. In this piece we argue that the time is ripe to look again to Europe as an opportunity and not as a risk to avoid at all costs.
The Importance of Diversification
In times of stress and major uncertainty, financial markets tend to see flight-to-safety behavior among investors, which often favors capital flows into the U.S. However, we would like to remind investors that contrary to this natural tendency, diversification actually matters most when risks are high, as they are today with all of the varied stresses currently facing the global economy. Whether it’s the war in Ukraine, one of the worst bond routs in recent history, geopolitical uncertainty from the UK to China to Latin America, the array of risks investors must consider are significant. However, the most attractive investment opportunities don’t emerge when all is well. Rather, they are found when fear and uncertainty permeate – a backdrop that may provide compelling entry points for patient investors.
Certainly the U.S. has outperformed, but that does not mean it’s wise to discard the basics of risk management and fully allocate to just one region. Investing in a single market, particularly one that trades at a premium as seen in the U.S. today, exposes investors to higher levels of diversification risk than they may appreciate. It is also dangerous to assume that what has worked so incredibly well in the past is likely to continue doing so in the future.
We particularly highlight that the U.S. equity market is materially concentrated in just a handful of stocks, recently peaking with more than 25% of the value of the MSCI USA Index in just 10 names. There is reasonable potential for lower earnings in these names in the near future which could sour the situation quickly, exposing investors to high levels of concentration risk.
Figure 1: U.S. Indexes Are Much More Concentrated than Their Emerging Markets Counterparts, Thereby Increasing Risks
Europe: A Tale of Two Stimuli – Potential for a Quick Recovery
While much of the world is currently dealing with inflation, the situation in the U.S. is particularly complex, tied to deep-seated issues resulting from fiscal and monetary policies implemented during the pandemic. It will take time for the consequences of these stimulus programs to work through the U.S. economy and for the resulting inflation dynamic to adjust.
The U.S. chose to pump money into the economy during the pandemic and now it has to recover from the accompanying side effects. Europe, on the other hand, was much more frugal, utilizing an approach that kept people working at reduced pay levels rather than utilizing the heavy blanket stimulus we saw in the U.S.
It is clear that Washington’s policy selection triggered a surge in money supply as shown in Figure 2, which illustrates the jump in U.S. M2 money supply growth compared to that of the Eurozone during the pandemic.
Figure 2: The Relative Surge in U.S. M2 Money Supply Makes Inflationary Pressures Harder to Cap
While Europe also faces inflation, it is largely a result of significantly different drivers than those faced by the U.S. Instead of stemming from an oversupply of money, European inflation is almost entirely tied to Russia’s invasion of Ukraine and the accompanying energy crisis. We can observe the components of euro area inflation in the chart below. Nearly three-quarters of the inflation is commodity-related and thus can eventually be tamed by improving supply-demand balances.
Figure 3: Euro Area Inflation Is an Energy Story
This is not to suggest we are ignoring the significance of the stresses from the Ukraine invasion, but it is important to understand that it is a single (although awful) shock that will eventually resolve. At that point Europe has the potential to recover faster than expected. Russia’s wartime success thus far has been far less than initially feared. The situation should only deteriorate for Moscow as their military runs down equipment, supplies, and manpower – all while the West has time to train highly motivated Ukrainian troops. We are certainly not predicting a quick victory as the most likely scenario and recommend positioning for a variety of outcomes. Although a positive (and perhaps sooner-than-expected) resolution for Ukraine appears to be a higher probability now than before.
An unanticipated conclusion of the conflict could lead to a quick bounce back for European equities even though the energy issues will likely take a long time to resolve. We can’t know if Europe will go back to using Russian gas as the continent works to secure permanent alternative supplies, or if they will stand firm on energy independence. Regardless, Europe’s energy balance will continue to improve, which removes much of the risk surrounding European equities.
Importantly, we believe that any resolution to the Ukraine conflict will allow the markets to look through to better times. Currently markets are pricing a permanent state of conflict. Yet we are already seeing improvements in the gas supply situation even as the invasion drags on. Individual countries have done well in building up supplies for the winter. As a result, we are seeing sharp drops in the elevated gas prices, which have contributed to Europe’s high inflation and associated economic risks.
Figure 4: European Gas Prices Have Fallen Sharply as Supply Worries Wane
Early in the crisis, many governments ordered their gas companies to fill storage capacity at just about any cost. As a result of this rush, we suspect that commodity speculators were enticed into the gas market, driving prices well-above fundamental value. As inventories filled (Europe currently sits at approximately 95% of storage capacity), gas prices retreated with various tenors of the TTF gas price moving down meaningfully (with TTF month-ahead down about 62% from its peak). Though winter 2023/24 is still in question with respect to adequate supply, European authorities are working through regulatory policies that should partially shield customers and businesses from the wild price swings of 2022.
Valuation: Europe Is Cheap
Against this backdrop, we think Europe looks very cheap for an appealing combination of diversification and upside potential. Looking past the energy crisis, there is a lot to like about Europe, and we expect investors to start paying attention in the near future as fears abate. We recommend taking advantage of current cheap valuations to diversify portfolios while also positioning for upside reward. To that point, 12-month forward P/E ratios for Europe and International (the MSCI ACWI ex USA Index, which includes Emerging Markets) currently sit at 32% and 31% discounts to the U.S. markets respectively – the widest levels of the last 15 years of U.S. outperformance.
Figure 5: Ex-U.S. Equity Indexes Remain at Steep Discounts to Their American Counterparts
A major factor in the underperformance of European and other international markets in 2022 has been the strength of the U.S. dollar. The flip side of U.S. dollar strength is that it allows U.S. investors to buy international companies at even more highly discounted values. Major international market currencies have depreciated to decades’ low prices with the Japanese Yen, Euro and British Pound falling about 22%, 16% and 13% respectively year-to-date vs. the dollar. Below are two measures of dollar strength including the Federal Reserve’s trade-weighted nominal broad dollar index and the DXY. We suspect the U.S. dollar strength is largely driven by rapid and aggressive Fed tightening to contain U.S. inflation. Though we are still not at peak Fed Funds rate, we believe that peak is approaching. When expectations of the awaited Fed pivot begin to settle, we expect to see major international currencies strengthen, all else being equal. Dollar moves can be sharp and meaningful in foreign index returns in USD – and USD weakness was a major factor in the 2002-2008 period during which Europe, and International Equities, outperformed the S&P 500.
Figure 6: The Dollar’s Strength Also Weighs on European Equities
How We Think About Investing in Europe in These Difficult Times
Global operators: We see attractive opportunities in companies that are based in Europe but operate on a global basis. Europe is home to many leading global companies across a variety of industries, and we feel these companies offer some of the most attractive investment opportunities at this point in time. Valuations have been dragged lower by Europe’s rolling crises, creating potential upside if issues resolve. But even if troubles continue, we believe these companies will continue to post earnings in line with global peers. This provides the all-important margin of safety – higher upside opportunity with less downside risk, and we think investors would be wise to take advantage of this opportunity. Some of our favorite names can be found in sectors such as pharmaceuticals and consumer goods, businesses that serve the world with essential products and minimal revenue exposure to Europe.
Beneficiaries of the current situation: Every crisis creates winners as well as losers, and active managers such as Thornburg Investment Management are well placed to take advantage of these opportunities. We continue to seek out companies that are performing well due to their exposures to certain sectors, industries and markets. We highlight companies such as those in the energy sector that have benefited from high prices and the ability to provide solutions in a difficult situation.
Bounce back stocks: As energy prices improve and the outlook for a resolution in Ukraine starts to look more favorable, companies that should benefit from this improvement start to become increasingly attractive. Industries that have suffered the most from high energy prices, such as chemicals and industrials, are likely to see the most dramatic recoveries. Investors may benefit from shifting exposures into these sectors and industries when the time is right. Though we are not calling for immediate allocation to these specific businesses, we suggest investors be aware of the value they could create in a turnaround scenario and consider rebalancing their portfolios now if they have been underweight European or international equity markets.
Some of the best investment opportunities emerge when fear is materially elevated – the Covid-19 drawdown and the global financial crisis are two such examples. We think we are amidst one of these opportunities now. Valuation, portfolio diversification and taking advantage of the multi-decade strength of the U.S. dollar are all compelling reasons for investors to look to the international stock markets, Europe in particular, for attractive investments. While home bias is a natural outcome in times of stress, we think the opportunity in international markets is too interesting to ignore.