JAN 2021

Outlook on Europe

RD22113

Summary• The COVID-19 pandemic may actually enhance returns

on investment for European companies. Many corporates are taking a very different view of their operations and cost bases. Those that adapt are likely to see better future returns, while those that do not could lag.

• Rising government debt-to-GDP ratios and uncertainty over future monetary policy are the major risks to the fragile recovery over the coming year.

• With a wide dispersion of returns across sectors likely in 2021, a focus on fundamentals and active management will be critical for identifying potential winners as we exit the crisis. The ESG leadership of European corporates may also offer generational opportunities for sustainability-focused investors.

• In fixed income, demand for high yield debt will likely remain high, given accommodative monetary and fiscal stimulus, while investment grade with a return close to zero is relatively unattractive.

European EquityThe Great RebasingWe believe that one of the long-term impacts of the COVID-19 pandemic will be an improvement in the returns on capital for a range of companies. COVID has caused many corporates to take a very different view of their operations, whether local or global, and given management teams an opportunity to re-evaluate their cost base. For many it has been a little like strictly enforced zero-based budgeting, whereby management set its budgets from scratch by re-evaluating and justifying each area of expenditure, rather than adjusting from the previous year’s figures. This includes variable costs, such as labour,

and also fixed costs like lease and rental agreements. Many companies are using this knowledge and adapting their business to move their operations forward in a more competitive way for the future. Whether they have renegotiated leases or reduced their workforce by necessity or through automation, all of these things will help permanently shift their future returns. On a bottom-up basis we have started to see management teams start to react and change their businesses, however we have also come across others that have not. In aggregate, this great rebasing will benefit the market, but it will be very stock-specific.

The disruption the pandemic caused to everyday commerce has also given management teams a better idea of where their company sits in terms of growth, cyclicality, and vulnerability to disruption. Some lines of businesses have been unaffected, allowing a stress-test of sorts. These companies will emerge from the crisis stronger, having identified their strongest product lines and distribution channels. Other industries were significantly affected by the virus, and the impact will weigh not only on the businesses themselves, but also on the market’s perception of such companies as investments. Automation and the growth of e-commerce have been key structural shifts of the past few years, and both are accelerating due to the crisis. However, the companies that wholly re-evaluated costs or streamlined products or services during this crisis are also likely to provide opportunities for investors over the coming years.

2020 has been a very tough year for management teams in general. We feel this is likely to cause a higher degree of turnover, which we generally see as a positive. New, more energetic management teams often enact the greatest degree of structural change.

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Finally, we believe in some areas that new capital is likely to have an advantage over previously committed capital. As such, “disruption” will continue to be a key risk across a range of industries. For example, lease agreements are now much more attractive than those for previous incumbents. Banks also have a lot of capital to lend (given the strength of balance sheets seen through this crisis) and at extremely low interest rates. The combination of low cost of capital and declining barriers to entry for younger companies in a range of areas is likely to support faster growth compared to disadvantaged established businesses.

Factors Supporting the Recovery in 2021The recovery period will begin in earnest as we move from the first quarter into the second, supported by continued monetary and fiscal support and vaccine roll-outs. However, this may also cause more style rotation as top-line growth will be less valuable due to an abundance of growth across the market. Many companies are likely to post impressive growth figures for the period between the first half of 2020 and 2021, and those impressive numbers could obscure which companies take market share or have more innovative products. This will make it harder during the first few quarters for investors to identify key trends and separate long-term secular growth from shorter-term cyclical growth.

Monetary Policy SuccessInvestors often look to US yield curve steepening for a sign of recovery, as it has been a key indicator historically. As a result, investors have largely overlooked the continued decline in long-term yields across southern Europe. The yield on the 10-year German bund remained steady throughout most of 2020, including in the fourth quarter. However, the spreads in European periphery countries such as Spain and Portugal have tightened significantly. The yield on Portugal’s 10-year government bond went negative for the first time in December, while Spain’s has fallen to near zero. This shows that the monetisation of the EU economy by the European Central Bank (ECB) has been effective.

We will closely follow whether the recovery in the first half of 2021 causes central banks to pull back on the monetisation of the economy and if governments continue to be fiscally extravagant or begin to address their significant debt balances by instigating austerity measures. These two scenarios are poles apart and will mean very different environments for equities. The choice will be just as important globally as it is in Europe. One canary in the coal mine that we will monitor particularly closely is the short end of the US yield curve. Two-year yields are at 12 basis points (bps) as we write and the US Federal Reserve has been particularly outspoken about the adverse impacts of negative yields. It will be important to watch what the central bank does if yields move lower.

Inflation and the market’s reaction to it rising could also change the status quo. With inflation currently running at very low levels, 2021 looks set to see a significant recovery and while it will partly confirm monetary policy success it is also going to be a test of the market’s ability to look through short-term data and its trust in central banks keeping their nerve. The year-on-year comparisons against very low numbers will mean that inflation will look like it is picking up quickly

at times and is likely to get near or even breach the 2% level that most central banks set as their target. While this is likely to confirm the recovery, it will also create speculation about tightening monetary policy. This is likely to be transient in nature, however given that the market tends to extrapolate data points (such as inflation) and assumes they will endure far longer than they actually do, we expect it to create pricing inefficiencies and thus opportunities for active investors.

EU Recovery Fund LaunchThe EU Recovery Fund began supporting government and central bank efforts on 1 January 2021. Around €750bn in funds will be released to member nations, including a significant portion earmarked to help Europe transition to a net-zero emission economy. The cost of the transition to clean technologies has been estimated to be around €28 trillion by 2050,1 which will be a significant challenge to the European economy. We expect a significant volume of applications for the recovery funds. The investment will likely be supportive for both small- and mid-cap companies, while larger companies in the construction, infrastructure, environmental, health care, and telecoms industries may also benefit.

Vaccine Roll-OutsThe distribution of vaccines are critical to the recovery. When the elderly and most vulnerable are protected against the virus, the strain on health care systems throughout Europe should ease, allowing them to work more effectively, and restrictions on normal life should begin to roll back as well. As some degree of normalcy returns, a boost to consumer spending is likely to follow.

Stronger Consumer Balance SheetsAn important aspect of this recovery has been the strength of consumer balance sheets compared to previous recessions. Through a combination of stay-at-home directives and the fiscal transfer to people whose jobs would otherwise have been made redundant, savings have grown (Exhibit 1) and both consumer borrowing and borrowing rates have fallen.

Exhibit 1European Household Savings Have Increased Sharply in 2020

Household Savings Rate (%)

5

10

15

20

25

30

Nov20

Sep20

Jul20

May20

Mar20

Jan20

Nov19

Sep19

Jul19

May19

Mar19

Jan19

GermanyUKSpain

France

As at 30 November 2020

Source: Exane BNP Paribas estimates

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Thus, consumers will enter the recovery period with money to spend and possibly pent-up demand to spend it. As long-term investors, we view this as more of a short-term impact, but we believe it will likely cause higher reported figures in the first and second quarters of 2021 and thus make it harder for the market to forecast the longer-term spending trends. However, investors are fond of earnings growth and momentum and companies are likely to show both in the first half of the year.

Rising Government Debt and Brexit Risks RemainBoth in Europe and around the world, the combined effect of borrowing to fund spending that supported economies through the pandemic and the sharp drop in output and demand has resulted in debt-to-GDP ratios reaching unprecedented levels in some countries (Exhibit 2).

At the country level, Germany’s ratio is viewed more favourably given its historical fiscal prudence, but those of Greece and Italy are significantly higher. One of the biggest downside risks to the recovery is if investors begin to doubt countries’ ability to finance their debts. Although spreads on government bonds tightened towards the end of the year, the market will be closely watching if they start to widen again as a warning sign that countries may no longer be able to finance their borrowing. A time will come when fiscal transfers and government support will have to stop to curb rising debt levels. When that happens, bankruptcies will likely increase, a trend we do not think the market has fully factored in yet. A spate of bankruptcies would increase unemployment across the euro area in 2021. The challenge for governments is to avoid pulling support too soon, with the apparent end of the pandemic in their sights.

With an agreement now in place, Brexit may be one less uncertainty the market has to grapple with in the year ahead. While on face value the outcome looks positive as it avoids the biggest risks and keeps much of the status quo, the lack of agreement on services and uncertainty over the democratic nature of the mechanisms to manage the agreement will likely create some concern. The key will be the finer details, the implications of which may not be clear for some time, as a shift in a trading relationship on this scale at a single moment in time is unprecedented.

Europe Set to Benefit from Growing ESG TrendsThe flow of funds in 2020 was highly supportive for environmental, social, and governance (ESG) trends. Global sustainable fund inflows were up 14% in the third quarter of 2020 to nearly $81 billion, with Europe accounting for around 77% of the total flows.2 This trend is highly supportive for European corporates, which were already ahead of their peers in other regions on ESG issues and continue to push forward, aided by supportive government policy and agency bodies. Companies that score highly on ESG factors may reap higher benefits in the future as governments, consumers, and investors increasingly demand more sustainable operations, while those that ignore or score poorly are likely more at risk.

With a significant portion of fiscal spending now set aside for green issues, particularly related to power generation and accelerating the shift to renewables, European companies are well placed to benefit. As governments look to rebuild their economies after the crisis, recovery funding will focus on mitigating the effects of the pandemic while building upon the frameworks developed for initiatives such as the European Green Deal. We believe investors may be underestimating the multiplier effect that will come from this spending, since it is likely to have a compounding impact across the entire value chain.

The pandemic has also strengthened the case for sustainable investing, as many funds with stronger ESG-credentials were shown to outperform during COVID-19 in 2020.3 We believe Europe will continue to be a major beneficiary of this generational shift in investor capital towards greener and more sustainable companies.

Overall, there is a lot to be said for European equities in the coming year as managements start from a lower cost base and the recovery takes hold, supported by vaccine roll-outs and accommodative monetary and fiscal measures. However, with a wide dispersion of returns across sectors likely in 2021, a focus on fundamentals and active management will be critical for identifying potential winners as we exit this crisis. The ESG leadership of European corporates may also offer generational opportunities for sustainability-focussed investors.

Exhibit 2Government Debt-to-GDP Figures Are Approaching Dangerous Levels Within Europe

Government Debt to GDP Ratio (%)

0

50

100

150

200

Est

onia

Bul

garia

Luxe

mbo

urg

Swed

enC

zech

iaN

orw

ayR

oman

iaLi

thua

nia

Den

mar

kLa

tvia

Mal

taPo

land

Net

herla

nds

Slo

vaki

aIr

elan

dG

erm

any

Finl

and

Hun

gary

Slo

veni

aA

ustr

iaC

roat

iaE

urop

ean

Uni

onE

uro

Are

aU

nite

d K

ingd

omS

pain

Cyp

rus

Fran

ceB

elgi

umPo

rtug

alIt

aly

Gre

ece

As at Q2 2020

European Union figures exclude the UK since 1 January 2020

Source: Eurostat

4

European Fixed IncomeThe final quarter of 2020 was a return to risk-on, with risky assets in very high demand. The European fixed income market exhibited a solid performance overall, with risky assets such as high yield, contingent convertibles (CoCos) or bonds from the European periphery performing best. Safer or less risky assets like German government bonds or euro-denominated covered bonds moved sideways. High yield spreads narrowed on strong investor demand.

Due to increasing COVID-19 infection numbers, restrictions have been tightened again in many European countries. The impact is less severe than during the first lockdown, but the services sector is nevertheless suffering from restrictions. For example, in Germany the IHS Markit Germany Services PMI in October was 49.5 and dropped to 46 in November.4 Although the index bottomed out in the period from March to May,the current index value is the worst since June 2009. This will change as vaccines become more widely available and infection rates decrease. Conversely, the manufacturing sector has been able to adapt well to the current environment. The seasonally adjusted IHS Markit Eurozone Manufacturing PMI only fell slightly during November (Exhibit 3).

Never have interest rates been as low and central bank balance sheets as inflated as they are today. After its meeting on 10 December 2020, the ECB decided to increase its Pandemic Emergency Purchase Programme (PEPP) bond-buying policy by €500 billion, resulting in a sharp expansion of the ECB balance sheet (Exhibit 4). It also extended the term of the programme by nine months to March 2022. Coupons and principals from the bonds purchased are to be reinvested until at least the end of 2023. As a result, prices for many assets are no longer cheap. However, monetary and fiscal easing will help offset recessionary pressures, at least for a while.

Due to government and central bank aid, risk premiums fell, and the insolvency rate for a recession period remained relatively low. However, insolvency rates are a lagging factor. According to Moody’s, default rates are expected to peak in March 2021. Therefore, the next couple of months are crucial. In addition, pandemic aid by governments and central banks obscured the difficulties of some companies that were struggling even before COVID-19 struck.

Investment grade debt remains relatively unattractive with returns close to zero, while demand for high yield is likely to stay elevated in the current environment.

Exhibit 3Euro Zone Manufacturing and Service PMIs Diverge during Lockdown Periods

Eurozone PMI

10

20

30

40

50

60

Services

Manufacturing

202020192018

As of 4 January 2021

Source: Refinitiv Datastream

Exhibit 4The ECB Balance Sheet Expanded Significantly in 2020

Central Bank Balance Sheet – Total Assets (€bn)

0

1000

2000

3000

4000

5000

6000

7000

Euroland

USA

202020182016201420122010200820062004

As of 4 January 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.

Notes1 Source: McKinsey (2020), How the European Union could achieve net-zero emissions at net-zero cost. www.mckinsey.com/business-functions/sustainability/our-insights/how-the-european-

union-could-achieve-net-zero-emissions-at-net-zero-cost

2 Source: Morningstar (2020), Global Sustainable Fund Flows Report. www.morningstar.com/lp/global-esg-flows

3 Source: S&P Global (2020), ESG funds outperform S&P 500 amid COVID-19, helped by tech stock boom. www.spglobal.com/marketintelligence/en/news-insights/latest-news-headlines/esg-funds-outperform-s-p-500-amid-covid-19-helped-by-tech-stock-boom-59850808

4 As of December 2020. Source: IHS Markit

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