European stocks fell 7% last week as the conflict between Russia and Ukraine continued to roil global, and especially European, markets.
There are two possible scenarios going forward.
(1) 𝑇ℎ𝑒 𝑐𝑜𝑛𝑓𝑙𝑖𝑐𝑡 𝑠𝑡𝑎𝑦𝑠 𝑐𝑜𝑛𝑓𝑖𝑛𝑒𝑑 𝑡𝑜 𝑈𝑘𝑟𝑎𝑖𝑛𝑒 𝑎𝑛𝑑 𝑅𝑢𝑠𝑠𝑖𝑎 𝑘𝑒𝑒𝑝𝑠 𝑠𝑢𝑝𝑝𝑙𝑦𝑖𝑛𝑔 𝐸𝑢𝑟𝑜𝑝𝑒 𝑤𝑖𝑡ℎ 𝑔𝑎𝑠.
In this scenario, the global economy will probably stay resilient. UBS, for example, estimates that oil at $110 for the rest of the year would lower global GDP by only 0.3 percentage points, while ING assumes that the hit to European growth from the conflict should be less than 1 percentage point. www.ubs.com/global/en/assetmanagement/insights/asset-class-perspectives/asset-allocation/articles/2022-03-macro-monthly.html think.ing.com/articles/stagflation-risk-increases-in-the-eurozone/
If so, stocks might be a good buy here. We use a rule of thumb that says markets should fall 10% for each 1% fall in GDP, while banks should fall 20%. That has already happened. “European equities are discounting a scenario in which war is protracted and the economic impacts are more severe than in our base case,” notes UBS.
To illustrate, a chart attached to this post shows the valuation history of one our positions, $BCS (Barclays PLC) . The stock now trades at a 5.8x PE (price-to-earnings). This is lower than at any non-recessionary time during the past decade. Only in the 2011-2012 European financial crisis and the March 2020 market crash did we see lower valuations, and then only briefly. Those were great times to buy.
It’s a similar story with the rest of our positions. Valuations are low and already discount a 1 percentage point growth slowdown. If that is all that happens, good returns will be available from cyclical Value stocks from here.
The alternative downside scenario is:
(2) 𝑇ℎ𝑒 𝑐𝑜𝑛𝑓𝑙𝑖𝑐𝑡 𝑒𝑠𝑐𝑎𝑙𝑎𝑡𝑒𝑠 𝑎𝑛𝑑 𝑅𝑢𝑠𝑠𝑖𝑎 𝑠𝑡𝑜𝑝𝑠 𝑠𝑢𝑝𝑝𝑙𝑦𝑖𝑛𝑔 𝐸𝑢𝑟𝑜𝑝𝑒 𝑤𝑖𝑡ℎ 𝑔𝑎𝑠.
This scenario was recently simulated by the The Kiel Institute for the World Economy. The outcome is that in the medium term, Europe’s GDP would hardly be affected, while Russian GDP would fall significantly.
This means that a rational Russia will not stop supplying Europe. But what if Russia acts irrationally? In an article entitled “Preparing for the first winter without Russian gas”, Bruegel analysts take a look at that scenario. The conclusion is that lights would not go out, but parts of Europe’s industry might have to shut down.
Central and Eastern European countries would be affected the most, while Spain and the UK would see a smaller impact, as their dependence on Russian gas is limited. Overall, European GDP might fall 3%. corporate.nordea.com/article/72663/ecb-watch-the-price-of-flexibility
In this scenario, we would expect a further hit to consumer and business confidence, and possibly a global recession. As for what would happen to the stock market, the closest historical parallel is the 1973-1974 crash, when stocks lost about half of their value. This would vindicate Bank of America’s call for a “bear era of government intervention, social & political polarization, Main Street inflation and geopolitical isolationism.”
The Kiel Institute simulation suggests that things would get back to normal after the recession, however, so the recession would probably create good buying opportunities.
Our bias is towards scenario 1, so we continue to maintain our European positions and wait for a recovery. Buying when others are pessimistic has been a successful strategy for us and others historically, so we are (almost) always happy to buy shares from the pessimists. Since scenario 2 can’t be ruled out, though, we’re not going all in for the time being and maintain a few more defensive positions as well.
The plan this week is to reduce (but not eliminate) Financials exposure and open positions in a few oversold European non-financials.
𝗔𝗿𝘁𝗶𝗰𝗹𝗲 𝗼𝗳 𝘁𝗵𝗲 𝘄𝗲𝗲𝗸
“Global Investment Views – March 2022”
– Amundi believes that “the rotation favouring value is a medium-term trend supported by rising real rates.”
– They are neutral on European equities in general due to the ongoing war, but see opportunities in Financials, Industrials and Healthcare – also our preferred sectors.