Martin Skanberg – Fund Manager, European Equities, Schroders
Robust demand could continue to buoy eurozone shares going into 2022, but risks will continue to build as the year progresses.
- The robust recovery in demand is expected to support share prices in early 2022
- Europe benefits from market-leading companies in ‘green’ technology and other innovative, fast-growing industries
- There is a risk that higher inflation expectations may become entrenched, and central banks face a difficult balancing act given the high government debt levels
Europe is entering 2022 with an abundance of strength in terms of demand. Corporate profits have soared and there is a wave of investment coming as companies reconfigure their supply chains and pivot to sustainable technologies. However, there is the prospect of higher inflation, higher interest rates, and potentially a very different investment landscape, especially towards the end of the year.
Recovery to continue in near term
In recent weeks, Europe has seen rising Covid-19 infections, and as a result some countries have re-introduced restrictions. However, prolonged lockdowns – as we had at the start of the pandemic – appear unlikely. Vaccination levels in developed European countries are high, booster vaccines are coming and there is the prospect of Covid-19 treatments in pill form.
New variants pose an additional concern. So far, we don’t see the current rise in infections as likely to cause widespread disruption or halt the recovery. Corporate profits in the eurozone are forecast to be up by about 50% year-on-year for 2021 and growth of 8-9% is expected for 2022.
Demand has so far been sufficiently robust that many companies have been able to raise prices to offset rising operational costs. We see some signs indicating that we may have already reached the peak for certain cost pressures – such as for some metals.
Companies which have been able to pass on those rising costs could find themselves in a very strong position in 2022 in terms of profit margins if cost pressures abate.
Is inflation becoming anchored in expectations?
But while some input costs may be peaking, there are reasons why inflation may not fall back.
Supply chains are being reconfigured due to both pandemic disruption and geopolitical concerns. Companies and countries want to ensure security of supply in the future. This reconfiguration, however, will lead to higher costs as companies seek suppliers who are closer geographically but may not be such efficient producers.
Higher carbon prices are also adding to costs; the EU carbon price doubled in 2021. This is a necessary step in the move away from polluting fuels and to incentivise spending on greener methods of production, but it does push up inflation.
Many industries are facing labour shortages which may force up wages. Energy prices are already sharply higher, and workers may seek higher salaries to offset this rising cost of living.
There is a risk that all these higher costs contribute to expectations of higher inflation becoming increasingly entrenched. Moderate inflation is generally good for equities because it is associated with positive economic growth and rising profits. But if costs rise faster than revenues then profit margins are depressed.
What will central banks do?
Central banks have a fine line to tread between keeping inflation under control and ensuring borrowing costs do not rise too far given high government debt levels. This is a particular concern for countries like Italy.
In response to higher inflation, the US Federal Reserve has already announced that it will wind down its pandemic emergency asset purchases. The question is when higher interest rates will follow.
The European Central Bank is expected to end its own pandemic easing measures in early 2022. Interest rate rises are some distance off. However, some smaller central banks, such as Norway, have already increased interest rates and the direction of travel is clearly upward.
Which sectors can benefit from these trends?
Europe is well-placed to benefit from the trend of re-shoring supply chains. In particular, the capital goods sector – makers of machinery, tools and other assets used in the production process – could be a significant beneficiary.
Then there are the technology leaders. Notable among these are Europe’s semiconductor equipment firms who are experiencing soaring demand as the world digitalises and chipmakers build out extra capacity.
Meanwhile, financials and especially bank stocks tend to fare well when inflation and interest rates are rising, as it enables them to reprice loans. However, consumer-facing stocks could find themselves vulnerable if wage increases fail to offset higher inflation.
‘Green’ spending can boost European companies
There is still significant stimulus coming through in Europe. The long-term EU budget and Next Generation EU spending covers the period 2021-27. Much of this spending will be directed to projects designed to prevent or mitigate climate change.
We see potential in industrial companies for whom the green energy space is a new growth area. Companies operating in niches like process technology or heat transfer and separation have opportunities to expand into new segments like green hydrogen production.
More generally, Europe has many companies which are market leaders in sustainable technologies, such as renewable fuels, electric cars or metals recycling. These companies could be poised to benefit from a greater focus on sustainability and climate issues around the world, not just in Europe.
It’s not the case, however, that every company in the “green” space will prove a good investment. Some, such as wind turbine makers, have seen their profit margins severely hit by poor execution on orders and higher raw material costs. Investors will still need to be very selective when it comes to individual stocks.
And the “age of innovation” extends beyond climate-related investments. Europe also has market-leading companies in industries such as life sciences which are seeing huge amounts of investment and exciting new product launches.
Risks may build in second half of year
We think the current strong momentum in shares will continue into the early part of 2022. Further mergers and acquisitions could add extra impetus as companies seize their last chance to take advantage of cheap money.
However, the risks posed by inflation and central bank action (or inaction) could build as 2022 progresses. Companies will also face tougher year-on-year comparisons when it comes to their quarterly earnings.
We must also recognise that Europe doesn’t exist in a bubble. Events in other economies – notably China – will also have a bearing on stock market returns in Europe. China’s economy has slowed and while there may be stimulus to come it will take time to feel the effects.
We could also point to geopolitical risks. Tensions between the US and China could flare up again, but there are risks closer to home as the migrant crisis on the Belarus-EU border shows. The French presidential election in April will also be closely watched by investors. Stock markets generally are at elevated levels so a geopolitical shock could easily cause a pullback.
Nevertheless, Europe may be better placed than some other regions to face a more challenging year. It’s a region that already has a high fixed cost base, whereas those with variable costs will feel a greater impact from increases. Europe’s banks are also in good shape to weather a tougher economic environment.
Eurozone shares have performed very strongly since the spring 2020 pandemic lows. The region’s MSCI EMU index trades at a growing premium to global non-US markets (as the blue line in the chart below shows). Yet eurozone valuations have not narrowed against the US (yellow line). It could be that Europe emerges as a relative winner, in what is likely to prove a more difficult year overall.