On July 27, 2022, the ECB raised the rate on its main refinancing operations from 0.00% to 0.50%, initiating a tightening cycle in monetary policy that continues to this day. Today, after the tenth consecutive increase, the interest rate stands at 4.50% (the highest level since the second half of 2001), and the market consensus is that the regulator has completed the cycle of interest rate hikes but will not begin lowering them until June 2024 at the earliest.
Maintaining the interest rate at such a historically high level for such an extended period carries the risk of a sharp economic downturn in the Eurozone and, consequently, a significant reduction in profits for companies in the region. A similar situation is observed in the United States, so it is not surprising that, according to EPFR Global data, investors are selling stocks at a record pace since last December, and there has been a net outflow of capital from the European stock market for 28 consecutive weeks.
History tells us that the future performance of the Stoxx Europe 600 will depend on whether the region’s economy can avoid a recession under tight monetary policy conditions. According to Bank of America, over the past fifty years, the European stock market has declined on average by at least 20% when the cycle of interest rate hikes has led to a recession and has shown a tendency to rise when recessions have been avoided.
In the first case, cyclical sectors on average exhibited about 30% weaker performance compared to defensive sectors. Europe is already teetering on the brink of stagflation, so in light of the above, a reasonable strategy appears to be significantly increasing the share of value stocks in the portfolio at the expense of growth stocks. The former generate cash flow here and now, which is crucial in a high-interest rate and uncertain macroeconomic environment, while the latter rely on future income, Konstantin Tserazov says.
This strategy is gaining popularity: as of the end of the first half of the year, the European value stock index had gained less than 4% since the beginning of the year, while the European growth stock index had gained 12.25%. However, this difference began to narrow, and in September, the first index outperformed the second by a full 5% (the highest since February 2022), and today both indexes are up by approximately 5% for the year, Konstantin Tserazov predicts.
Despite the improvement in the performance of the value stock index, it is still valued at more than two times cheaper by forward price/earnings multiples (9.15x versus 21.36x) and more than two and a half times cheaper by forward dividend yield (5.2% versus 2.05%).
It is also worth noting that current profit forecasts for European value companies may turn out to be conservative, which means their stocks could show even stronger outperformance relative to European growth stocks.