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Cracks in the European Building


The year 2018 is proving difficult for European investors. However, optimism prevailed at the passing of the year, most strategists were forecasting a positive stock market with outperformance for the European equity markets. A healthy economy, a benevolent central bank, and according to some, attractive valuations compared to the US market were the main reasons for the positive forecasts.

Comparisons are misleading

The reality is different. We wrote about it in March of this year. We believe that there is reason to continue to be worried about the European project. It is highly likely that the risk premium on European equities will increase in the coming months.

At first, we need to come back on one important point: When comparing equity markets in Europe and in the USA, one must be remembered that sectors weightings are not the same.

Example with MSCI indices :


Weigth(%) Weigth(%)

Cons. Discretionnary 10.6 13.1 -2.5

Cons. Staples 13.4 6.7 6.7

Energy 8.3 6.2 2.1

Financials 19.4 13.8 5.6

Healthcare 12.9 14.1 -1.2

Industrials 13.0 9.8 3.2

Information Tech 5.5 25.9 -20.4

Materials 8.4 2.7 5.7

Real Estate 1.4 2.8 -1.4

Telcommunications 3.4 2.0 1.4

Utilities 3.6 2.8 0.8

Value Value Spread

Forward P/E 13.9 16.9 -3.0

Price to Book Value 1.9 3.4 -1.5

Since 2000, the European market discount on a comparable sectoral basis is around 8%. Currently this discount is 6% (source Thomson), which means that there is no "bargain" to be invested on Europe. A discount is justified because the profitability of European companies is lower and the governance not as good. The reasoning is the same in emerging markets, even more blatantly.

If a strategist advances the argument of valorization without putting it in perspective, run away, the analysis is worthless.

A great unfinished project

It is true that the US willingness to bilaterally renegotiate most trade agreements rather than multilaterally has thrown a chill and injected a degree of uncertainty into the evolution of world trade. However, the European economy began to slow down early in the year, well before Donald Trump's ranting. Confidence indicators have fallen since high levels and the demand for credit is weakening in the Eurozone. ECB is fully aware of this, this one of the reasons why M Draghi will not raise rates until June 2019. Stress in the Italian bond market could even further delay any monetary policy tightening.

There are worrying political signals for Europe, at an important moment in its history. Europe is a great project, over the last 50 years, achievements have been incredible. In 2018, three generations later, Europe is indeed a financial and economic reality, a global giant, but unfortunately not yet a political reality, that is where the shoe pinches.

The project has come to a halt for many years now. And this is where the major risk lies, because the last stages of integration are the most important and the most difficult. There are transfers of sovereignty to be made, from member states to Europe. One must organize the common budget, taxation, the diplomacy, the army, the police and solidarity through fiscal equalization and European public service companies. We have not seen any initiatives on these topics in recent months or years, only technicalities are on the agenda, except for migrants where there is no consensus among Europeans.

Populist threat

Populist movements are gaining momentum in Europe. A large part of the European population does not benefit from the recovery, the impoverishment of the middle class is a threat for all Western countries, but the threat could have more important consequences in Europe, because it is a financial and economic heavyweight but a political dwarf. Who knows the European government? It should be the most important executive body in Europe. Populism is inward-looking and exacerbation of fears, Europeans need collaboration and openness.

Some recent examples of the success of the “national” populist Europhobes.

Austria going east

When the far-right party FPÖ came to power in 2000 along with the traditional right, Europe's reaction is, at that time, very strong: diplomatic relations are broken, Austria becomes an outcast in the very heart of Europe. Monster events are organized in the country and abroad against the coalition. Fast forward to 2017, the FPÖ goes back to the government and it has not made waves, yet the FPÖ’s ideas have not changed. Better still, Putin is invited on 18 August to the wedding of the Austrian Foreign Minister Karin Kneissl of the FPÖ, a strong political signal. There was no official comment from Europe, not one.

Bad habits in Poland

The judicial reform that will allow the Polish government to appoint the president of the supreme court is bending the values of independent justice. An infringement procedure against Poland is in progress. The Polish government is clearly Europhobic, despite the many subsidies that the country receives.

Long time ago in Czech Republic

For the 50th anniversary of the Prague Spring, a few ceremonies are organized, no big crowd attends them, young people are not interested. Czech President Milos Zeman does not participate because he is pro-Russian.

Authoritarian Hungary

Media freedom of speech is restricted. Georges Soros, who finances a university in his home country, is described as "an enemy of the people" by a member of the government. Hungary has banned universities registered abroad from providing courses on national soil. The law specifically targets the University of Mr. Soros. The government has become popular because of its uncompromising attitude towards migrant flows.

Germany is hiding

Merkel is reelected but weakened. She is a pragmatic pro-European. Welcoming more than one million migrants in 2016 cost her dearly. Germany must be one of the engines of European integration along France. Bavarian CSU is also playing with people’s fears, populists are gaining ground under the pressure of far-right party AfD.

Brussels new comer

Steve Bannon, former special advisor to President Trump announced that he was establishing his "The Movement" foundation in the Belgian capital. This is not trivial. He is a media man who wants to boost far right ideas across Europe. It confirms that today there is a political space for hard-liner nationalists. The rhetoric of withdrawal and "foreigners = danger" is no longer a foil for the European electorate.

UK and the Brexit

Brexit is a mess. This shows that it is difficult to leave the Union without creating significant legal problems and especially a great uncertainty, harmful to the economy. A populist rhetoric won the Brexit vote, now we face the complexity of dismantling what has been built in the last 40 years.

The main danger comes from Italy

It is a key country of the European venture. Matteo Salvini behaves like the head of government and phagocytes his allies. The far-right foreign minister has made the headlines by refusing to allow refugees from the “Aquarius” to land on Italy’s shores. He has already announced that Europe will put Italy under pressure during the discussions on the 2019 budget in September, and the country should not allow itself to be pushed around. His reaction after the collapse of Morandi Bridge in Genoa was a model of bad faith and untruth. The European Commission issued an official statement to deny his false charges, one could have expected President Macron and Chancellor Merkel to put M. Salvini back in line. Thanks to his populist stance, Mr. Salvini is more popular today than when he came to the government.

This comes at a time when Europe is lonely, his American friend has moved away. It had begun before the arrival of D. Trump at the White House, with his election the process accelerated. After all, Mr. Trump is a populist. The United States will not help Europe, on the contrary, they will not hesitate to divide it.

The same goes for Putin who will not hesitate to divide the Europeans, each time there is an opportunity. His coming to Graz was a very successful media coup. He will encourage all initiatives that will attract sympathy for him. For him it is even better if Europe undermines itself from the inside.

There are cracks in the European project. These cracks need to be taken care of, otherwise the whole edifice will collapse. It is not a forecast, it will happen if Europe doesn’t become a united country.

Financial markets will take notice

The financial markets have begun, timidly, to take these elements into consideration. It is expected that the risk premium will continue to grow before the next European elections in May next year. In the meantime, the Italian budget negotiations will be in the spotlight. Conti's government will probably want to implement a stimulus budget, with a deficit much higher than what was announced by the previous Italian government (0.8%). The European Commission will look awkward because Italy is not Greece. An open conflict with one of the founding countries of the union would have a very negative effect on the risk premiums and credit spreads. Thus, the probability is high that the underperformance of European equities relative to the US will continue in the coming months, even in the context of lower equity valuations on a comparable basis.

To end on a positive tone, the young president Macron is a reformer. He beat the populists in France last year; will he succeed in rallying the Germans to his European cause? Let's hope so. In Spain also, a government led by the left could be a strong ally in a context of reforms, however elections will be necessary to strengthen the position of Mr. Pedro Sanchez in the Spanish parliament.

While there is life, there is hope.


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