Brace yourself! This could be the year when the world goes on holiday. None of this worrying about how on earth you will use all your holiday allowance by the end of the year in 2022! As Covid becomes less lethal, we think Europe is set to outperform – the stars are very much aligned. By extension, this is also the year we expect to see US exceptionalism ending, the USD falling and US assets underperforming.
Taking stock of where we are at the moment in the US
There’s a great deal of good news priced into US assets. US assets have outperformed throughout the pandemic and by extension so has the USD. Many investors in the rest of the world have benefitted from the double whammy of rising US assets as well as a rising dollar, which then leads more investors into the safety of US assets because the USD is rising, creating a virtuous circle of US asset outperformance.
However as we look forward, then things don’t look quite so rosy. With US unemployment at 3.9% the US is arguably already at full employment and any output gap closed. The US Federal Reserve has held on far too long without tightening financial conditions and the US economy is at threat of overheating with little spare capacity left in the system. Add in the fading US fiscal impulse that is likely to keep growth below forecasts, then the outlook for US asset outperformance and the USD itself is not a good one.
The market has moved swiftly to price in 4 rate hikes for this year. In short there’s a lot already in the price of US assets in general and by extension the USD.
Need for experiences
I don’t mind camping but surviving a named stormed on the first night of a family friendly festival last year did make me hanker for a warm, sunny and still(!) coastline in the Med. Foreign travel, especially if you have a family has been put in the too difficult box for many, but with Omicron likely in the rear view mirror as we get to the spring then things are looking up for foreign holidays. Having sunset drinks without a coat on could well be in sight!
Europe will rise from its low base
Markets trade the rate of change and the positive rate of change in Europe is likely to be rapid as we enter the spring. With Europe looking so poorly at present and having a had a very difficult Christmas period on a mash up of Delta and Omicron, European assets have done less well and clearly have the potential for outperformance.
A heavy reliance on tourism is often cited as the Achilles heel of many European economies, especially over the last couple of years. But, the longer the pandemic has gone on the more demand for overseas travel has pent up. When we look at this dependence on tourism – Greece at c.21%, Portugal c.19%, Austria c.16%, Spain c.15%, Italy c.13%, it’s clear these countries should do exceptionally well from a genuine opening up of economies and in particular cross-border travel.
Relatively high European unemployment
In contrast to the US, where the output gap has been closed, many parts of Europe are much less capacity constrained by labour availability. Once again, normally a drag on the continent’s growth prospects, as we enter 2022, this unemployment rate is actually a good thing. In contrast to the US, Europe has spare capacity to grow. With EU unemployment at 7.2% in November and within that Spain at 14.6%, Greece at 13.3% and Italy at 9.2%, these economies have the labour to throw at a stellar tourism season.
Oil unlikely to spoil the party
Europe is a huge net oil importer and as economies reopen in the way we are talking about, the oil price is likely to rise further. However, those with an ability to save during the pandemic years have been doing so and there is little evidence to suggest those savings have dwindled as yet. Those with a propensity to save will now have a propensity to spend and this can more than offset rising petrol prices and airfares. A higher Euro may well give the continent a helping hand in this regard.
Lift-off in European rates
The likelihood of a very strong tourism season is excellent for Europe as a whole. Those from Northern European countries with their heavier reliance on manufacturing will go south to holiday. Those from outside the bloc such as UK and the US will enter for sun and culture. Whilst Christine Lagarde may still be setting a relatively dovish tone at the ECB in comparison to her central banking peers across the globe, she will only be able to hold on to this for so long and with just a single hike of 15bps priced in European rates for this year, the market will need to move to price in more. European policy makers will see that their US counterparts have overheated an economy and will wake up to the fact that theirs may be on a similar course unless they change course and tighten monetary policy sooner.
A boon for Europe’s beaten up banks
Whilst this is all clearly very good news for Europe’s hotels and airlines, it is great news for European banks, particularly those in these very tourism heavy countries. It is excellent for loan book quality with the finances of SMEs improving along with the finances of the households that work for them. Rate rises are incredibly good for the European banking sector through margin expansion. Put rate rises and strong economic growth together and the ability to grow the loan book increases, because there’ll be increased demand for loans as businesses want to expand, but also an increased willingness from banks to lend because they are now getting paid more through margin expansion from higher interest rates.
A virtuous circle for Europe
All this leads us to think that we could get higher equities and tighter credit spreads this year as well as a strong Euro. Much the same dynamic we have seen in US assets for a while now, with outperforming US assets feeding into USD strength, which then fed back into strong USD assets, makes a great deal of sense for Europe in the short-term. We see this as potentially a great time to buy European assets and the Euro with not a great deal priced in.