Jan 2022

Outlook on Europe

RD22113

Summary• Uncertainties tied to the coronavirus remain in the short

term, but the European economy is set to enjoy higher-than-average growth this year.

• The European Union’s unprecedented fiscal stimulus could bear more significance than currently accounted for.

• European corporates should continue to benefit from the growing global interest in sustainable investing.

• The valuation gap between the top and bottom quartiles in Europe is greater than ever, highlighting the need for active management.

• Historic inflation numbers could undermine European fixed income and present a growing challenge for the European Central Bank.

European EquityWhile the impact of the Omicron variant of coronavirus will obscure the underlying growth trends of European companies in the immediate term, the economic environment of the region is improving. A longer-term implication of the pandemic is an effective reset of the economic cycle after a long period of growth before COVID-19, a shift that in turn guides investment decisions. Inflation rates are expected to decelerate but remain high compared to the levels seen just before the pandemic. European GDP and earnings are set to reach above-average growth, while the bloc’s fiscal stimulus is expected to accelerate the region’s economic recovery. Further, the stimulus aims to enhance the comparative ESG advantage of European companies against the backdrop of increased global cognisance of sustainability factors. The gap in valuations in Europe remains historically large, making careful bottom-up management crucial to mitigate risks and enhance investment outcomes.

Re-Emergence of the European Economy Investors have been eager for a ‘clean slate’ for the European economy. The emergence of new COVID-19 variants has led to a stop-start recovery and muddled the process of evaluating companies’ true organic growth profiles. A fresh start currently seems unlikely with the new Omicron variant spreading rapidly, causing a firmer government response in Europe as well as globally.

The emergence of yet another variant (and associated restrictions) has two knock-on effects in the short term: Firstly, companies whose business models are less vulnerable to lockdowns and other COVID-related effects—either inherently, or through successful adaption during the pandemic—stand to benefit relative to competitors in the very short term. Secondly, market volatility will likely remain elevated early in the year, as questions regarding the economic effects of the new strain linger.

Looking further ahead into the year, Europe and economies globally should enjoy relatively strong growth once the headwinds of coronavirus subside. Importantly, in our view the recession that resulted from the lockdowns marked a reset of an already mature economic cycle leading up to the pandemic. To a great extent this is now a new cycle, which further guides the type of companies that are likely to thrive in the coming period.

Global supply chains are expected to normalise somewhat throughout the year, supporting the recovery of many European companies. It will be important to monitor which companies can most effectively influence the flow of input elements in order to clear pent-up

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inventory. Pandemic-induced supply chain disruptions have further accelerated a shift towards companies localising some of their production. This is not achieved overnight—or even over the course of this year—but marks a significant shift, nonetheless.

Sentiment in the European economy has also improved markedly since the onset of the pandemic. There remains a divergence between industrial and consumer sentiment, with consumers remaining cautious as evidenced by their intent to make large purchases in the next 12 months (Exhibit 1). As the impact of COVID-19 fades some of this consumer caution could be alleviated, further unlocking growth upside for European companies.

An Unprecedented Fiscal ResponseThe European Central Bank (ECB) has cautioned for a while that monetary policy alone would not be sufficient to support the European economy during and post-pandemic. The pandemic has given Europe the impetus it needed to take their advice and coordinate a significant fiscal initiative, which marks an important shift from the economic paradigm that has until now shaped most European countries.

Besides national initiatives, the ECB has been the primary pillar for European companies during the pandemic, primarily through its €1.85 trillion pandemic emergency purchase programme (PEPP). While net purchases are due to end in March, a separate bond purchase scheme will continue—albeit less than half of the almost €90bn a month seen from the PEPP.

While the ECB is cautiously unwinding its stimulus support, the European Union (EU) has agreed on its largest-ever stimulus package, NextGeneration EU (NGEU), totalling more than €800 billion. The recovery package is designed to repair the damages from the pandemic and simultaneously accelerate the transition of the European economy towards a more sustainable future. There remain questions on the timing of individual nations’ loan take-up and subsequent

disbursement of funds to beneficiaries. However, there are reasons to be optimistic as the programme allows countries to borrow at a lower interest rate with limited impact on national deficits. The stimulus package should act as a growth multiplier and contribute to incremental GDP growth, including through spillover effects via EU trade linkages (Exhibit 2).

Combined with the accommodating monetary policy in the euro zone, this could bear more significance than investors are currently accounting for. Notably, Germany is veering away from its historical focus on balanced budgets, despite recently printing its highest inflation levels in 29 years.

The Inflation Dilemma There remains little doubt that we have entered a more inflationary period, and while this does not necessarily mean high inflation, it moves the economy away from the deflationary cliff edge that it has teetered on for some time. While input price increases in areas like transportation and power may have a more temporary effect on inflation, increases in wages and housing (house prices and rents) tend to be stickier and longer lasting. While the growth of input prices has decelerated, it remains steep relative to historical standards with no immediate reversal of this trend in sight.

This does not mean that rates will rise in Europe in the near term. despite of the upcoming end to the PEPP, Christine Lagarde, the president of the ECB, still views EU inflation as a passing ‘hump’, adding that a rate rise in 2022 is very unlikely.

A change in tone is more apparent when listening to the US Federal Reserve as the term ‘transitory’ was recently removed when describing the surging inflation in the US. The markets are starting to price in the first rate hike by the Fed, which is important for Europe as many of its major companies are strongly export-driven and therefore more impacted by the global environment.

Exhibit 1Divergence in European Sentiment

0

20

40

60

80

100

120

140

Economic Sentiment Indicator [RHS]

(Index) (Sentiment)

-40

-30

-20

-10

0

10

20

Consumer Confidence Index Euro Zone [LHS]

Industrial Confidence Index Euro Zone [LHS]

20212020201920182017201620152014201320122011

As at 30 November 2021

Source: FactSet and European Commission

Exhibit 2Fiscal Stimulus’ Expected Euro Zone Boost

(% of GDP Increase)

0

1

2

3

4

5

Spillover EffectNational Plan

Swed

en

Net

herla

nds

Ger

man

y

Fran

ceEU

Spa

in

Port

ugal

Ital

y

Gre

ece

As at 31 July 2021

Source: European Commission

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Europe’s Growing ESG Leadership The aforementioned fiscal stimulus by the EU demonstrates its strong commitment to improving the environmental impact of the European economy. The EU has pledged a significant amount of capital toward further developing wind and solar energy, as well as sustainable infrastructure, among other projects, which should benefit companies and industries that are aligning with net-zero goals.

Further, as investors around the world become increasingly cognisant of the importance of incorporating ESG issues into investment decisions, European companies generally lead in the ESG rankings and the region is well positioned to benefit from fund flows as this trend develops (Exhibit 3).

While there is a growing momentum around investing with ESG factors in mind, investors have also become increasingly aware of the need for transparency and rigour when analysing these issues. Europe has shown noteworthy leadership in this regard, for example via the SFDR regulation, which was implemented last year. This framework should help encourage inflows to European companies with a strong ESG presence, as asset allocations globally are increasingly influenced by regulations around sustainability.

An Evolving Political Landscape in EuropeAs expected, Germany formed a coalition government with Olaf Scholz as chancellor and it will start to implement its political programme in the year ahead. While a strong bond between Germany and France (where the presidential election is coming up this April) has existed for many years, new political alliances are also likely to be constructed. France and Italy have started to improve their relationship, prompted by the appointment of the new prime minister of Italy, Mario Draghi, who was formerly head of the ECB. Draghi’s gravitas among the leadership of Europe might make Italy more politically acceptable and help pave the way for new agreements.

The continued discussion between the EU and the UK regarding the border of Northern Ireland, and how the flow of trade will continue in the longer term, is also worth keeping an eye on. For now, tensions seem to have eased after the UK recently issued some of the much-debated fishing licences to the EU, but the relationship between the two parties are still in need of some reparation.

The Valuation Gap Remains The significant gap in valuation between the top and bottom quartiles of the market is something we have been monitoring for a while and it is still looming large. Currently, there is a subset of securities, especially within the technology and consumer discretionary sectors, that are trading on multiples previously unheard of, both for long-standing and newly listed companies. It will be crucial to actively monitor how this historically high gap develops over the year.

The market has shrugged off this disparity so far, but any significant shift in attitudes towards these valuations could have important investment implications. It would not only affect the type of companies that will outperform in the year ahead, with companies that have not enjoyed the same price momentum in recent years standing to benefit, but also the market level overall, seeing that many of the highest-valued companies are also some of the largest constituents. The historical gap in valuation further calls for careful bottom-up management in order to mitigate risks and enhance the investment opportunities that arise as the year develops.

European Fixed IncomeThe previous quarter marked a turbulent period for European fixed income with bond markets focussed on inflation numbers. Euro zone inflation climbed to 4.9%, which constitutes the highest number since July 1991. In almost all European countries inflation numbers were steeper than expected and reached multi-year highs (Exhibit 4), leading to widespread calls for tighter monetary policy.

Exhibit 4Surging Inflation in Europe

(%)

-1

0

1

2

3

4

5

6UK GermanyEuro Zone

20212019201720152013201120092007200520032001

As at 15 December 2021

Source: Refinitiv Datastream

Exhibit 3Europe’s ESG Advantage

(% of Companies)

ESG Ratings

0

5

10

15

20

25

30

35

40MSCI ACWIMSCI Europe

AAAAAABBBBBBCCC

As at 30 November 2021

Percentage of companies that fall under the different MSCI ESG ratings.

Source: MSCI ESG Research

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The ECB stated that most of the upside surprise was likely transitory due to supply chain problems and energy price inflation. However, inflation may prove to be more than just transitory. Base effects and the record-high increase in energy prices will fade, but it can be assumed that the general price level will settle at a higher level than before the pandemic.

Therefore, the ECB is facing one of its most difficult tasks in a long time. Considering the dramatically rising prices, the ECB has to assure that inflation will not get out of hand. In our view, there will be little leeway to maintain the ultra-accommodative monetary policy in the coming years, although the ECB will also be careful in unwinding its monetary support while uncertainties tied to the pandemic remain.

At its December meeting the ECB presented its policy outlook for 2022. As expected, the ECB announced the end of the PEPP, effective March this year. Nevertheless, it will continue to support markets through the general Asset Purchase Programme (APP). The ECB holds on to the narrative of transitory inflation and interest rates remain unchanged for now.

The Fed has taken a different approach as it decided to reduce its bond purchases even more than previously expected, paving the way for several interest rate hikes during 2022. The Fed’s outlook for the path of interest rates suggests that Fed members expect three rate hikes this year. Therefore, one of the discussion points for European fixed income investors will be the diverging policy paths between the Fed and the ECB in the coming quarters. Markets usually suffer under uncertainty and increased volatility in times when central banks move in different directions. Meanwhile, at its December meeting, the Bank of England raised interest rates by 15 basis points to 0.25%, as inflation jumped to 5.1% in the United Kingdom. This represented the sharpest rate hike in over a decade.

Nominal yields on European ‘safe-haven’ government bonds have already been in decline for a long time. Due to high investor demand for safe assets in crisis situations, this trend accelerated during the pandemic and nominal rates achieved new record lows. In real terms, the high inflation numbers represent an even greater burden on fixed income. Dramatically rising inflation numbers have led to deep negative inflation-adjusted yields on ‘safe’ assets (Exhibit 5). Due to their negative real yields, European government bonds do not offer any protection against inflation. European corporate bonds offer relatively more inflation protection (especially investments like high yield), but corporate bond yields are also trading near historic lows and therefore offer limited cushioning (Exhibit 6).

We still believe that Europe will trend towards further recovery during 2022, although there are notable risks. The most important discussion point for European fixed income is undoubtedly inflation and the central bank’s policy path in the coming quarters. The primary question for investors this year will revolve around how fast and how firmly the ECB will fight inflation, a balancing act that poses the main threat to European fixed income.

Exhibit 5European Real 10-Year Government Bond Yields

(%)

-6

-5

-4

-3

-2

-1

0

1

2

3

UK

Spain Italy

Germany

20212020201920182017

As at 16 December 2021

Source: Refinitiv Datastream

Exhibit 6European Corporate Yields

(%)

0

5

10

15

20

25

30

Ice BofA European High Yield

iBoxx Euro Financials

iBoxx Euro Corporates

2021201920172015201320112009200720052003

As at 15 December 2021

Source: Refinitiv Datastream

Outlook on Europe

This content represents the views of the author(s), and its conclusions may vary from those held elsewhere within Lazard Asset Management. Lazard is committed to giving our investment professionals the autonomy to develop their own investment views, which are informed by a robust exchange of ideas throughout the firm.

Important InformationPublished on 10 January 2022.This document reflects the views of Lazard Asset Management LLC or its affiliates (“Lazard”) based upon information believed to be reliable as of the publication date. There is no guarantee that any forecast or opinion will be realized. This document is provided by Lazard Asset Management LLC or its affiliates (“Lazard”) for informational purposes only. Nothing herein constitutes investment advice or a recommendation relating to any security, commodity, derivative, investment management service or investment product. Investments in securities, derivatives and commodities involve risk, will fluctuate in price, and may result in losses. Certain assets held in Lazard’s investment portfolios, in particular alternative investment portfolios, can involve high degrees of risk and volatility when compared to other assets. Similarly, certain assets held in Lazard’s investment portfolios may trade in less liquid or efficient markets, which can affect investment performance. Past perfor-mance does not guarantee future results. The views expressed herein are subject to change, and may differ from the views of other Lazard investment professionals.  This document is intended only for persons residing in jurisdictions where its distribution or availability is consistent with local laws and Lazard’s local regulatory authorizations. Please visit www.lazardassetmanagement.com/globaldisclosure for the specific Lazard entities that have issued this document and the scope of their authorized activities.This report is being provided for informational purposes only. It is not intended to be, and does not constitute, an offer to enter into any contract or investment agreement with respect to any product offered by Lazard Asset Management, and shall not be considered as an offer or solicitation with respect to any product, security, or service in any jurisdiction or in any circumstances in which such offer or solicitation is unlawful or unauthorized or otherwise restricted or prohibited.