Outlook 2023, European equities: can easing energy prices aid a recovery?
After a tough 2022 for Europe, we think beaten down sectors such as banks and small caps could be due a reversal in fortunes.
The question for 2023 is whether markets can win out over the difficult macro backdrop.
Hopes that inflation may have already peaked, in the US at least, have lent support to shares recently. This better stock market momentum may well continue into the first part of 2023, but could fade later in the year.
Moderating energy prices to offer support
Following the sharp energy price rises following Russia’s invasion of Ukraine, the market has been waiting for the eurozone to enter recession. It hasn’t happened yet.
Energy prices are now moderating, and the year-on-year comparisons will become easier. Recession still looks the most likely scenario, but these moderating energy prices may mean the recession is shorter and shallower than it might otherwise have been.
Just as the expected recession has not arrived yet, neither has the anticipated sharp downgrade to corporate earnings.
More moderate energy prices would be a boon for corporate profit margins. Another positive influence is the ongoing unwinding of the supply chain disruption caused by the pandemic.
Both factors could help profits to remain resilient, even as additional cost pressures come from higher wage demands.
Momentum could fade as year progresses
But at the same time, it’s undoubtedly true that the economic backdrop will be difficult in 2023. Even if inflation moderates from its current levels (10.0% in November 2022) it’s unlikely to fall back to the European Central Bank’s (ECB) target level of 2%.
The ECB is still on course to begin “quantitative tightening” next year: shrinking the size of its balance sheet by replacing fewer maturing bonds. What this means in practice is tighter liquidity – less money flowing through the financial system – which is generally not a good thing for equities.
We also have to consider that higher interest rates mean higher financing costs for governments, corporates and individuals. As a result, consumption and investment are likely to be hit.
As quantitative tightening takes place, and debts start needing to be refinanced, we may see any early positive momentum for the stock market fizzle out.
Reversal of some 2022 moves
Taking a step back, we do think some of the outsized market moves of 2022 are likely to see at least a partial reversal in 2023.
If US inflation is indeed under control then we could see the dollar weaken as the Federal Reserve pauses its rate hikes, or even starts to cut, while other central banks are still raising rates. A weaker dollar can be helpful for international equities, including European shares, partly because commodities priced in dollars (like oil) become cheaper.
In terms of sectors, energy was the top positive performer in the MSCI Europe ex UK index in 2022 with a 27.9% gain (year-to-date as of 31 October 2022). The sector is unlikely to outperform the index to such an extent in 2023.
The table below gives an indication of why sector performances might reverse. Some sectors that have done well this year – energy, materials – are forecast to see earnings shrink in the following 12 months (see column EPS growth FY2).
If Europe does enter recession, downgrades to corporate earnings are likely to ensue. Those companies and sectors that can potentially provide some earnings stability will therefore be a key focus for investors in the coming 12 months.
Banks are a sector that could do well. Many eurozone banks are still looking attractively valued and higher interest rates are positive for the repricing of loans. Clearly, a recession would cause a rise in bad debts, but if that recession is short and/or shallow then the negative impact would be more limited than some might fear.
Economically-sensitive sectors such as capital goods or semiconductors could also fare relatively well, especially if any recession proves short-lived.
Meanwhile, an area that has particularly suffered in 2022 is small and mid-sized companies. Again, we could see some of this reverse.
In general, more favourable sentiment towards shares tends to result in outperformance for small cap stocks compared to large caps. The chart below shows how this has been the case in previous market cycles.
Not time for aggressive positioning
Broader, long-term trends could support certain pockets of the market. While investment generally may fall amid higher financing costs, we do think the trend towards more localised production will continue.
Another area of focus for investment will be defence as governments increase spending in the wake of the war in Ukraine.
The energy transition remains a key theme for Europe but energy security has become paramount. Investment may be channelled to those projects giving the quickest return in terms of security. It’s striking that Germany recently completed construction of a new liquified natural gas terminal in just 200 days, whereas renewable projects like wind farms typically take much longer.
We do think the worst case scenario of a steep, prolonged recession can be avoided. This would support better sentiment towards eurozone equities, particularly as the region is currently extremely out of favour with investors.
Even a moderately better year for Europe could catch out many in the market. Positioning has been very negative with investors deserting higher risk areas, including small and mid-sized companies (see chart below). Any better performance could see this change swiftly.
The big “known unknown” is the war in Ukraine. Given that, and the uncertainties around the growth outlook, it’s not a time for aggressive positioning.
As ever, our focus will be on the best stock-specific opportunities across the whole market, focusing on the pockets of growth that can always be found, even in more difficult economic times.