Markets Priced in Weak Eurozone Growth Long Ago

A spate of eurozone data ranging from industrial production to retail sales came out last week and the results were, well, not pretty. It all suggests the eurozone’s recent flattish growth and Germany’s mild contraction may persist or even worsen somewhat. But markets have long anticipated eurozone economic weakness—especially in Germany. Stocks look forward, so this isn’t coming as much of a shock—and, counterintuitively, it could help investors move on from these fears.

No question eurozone economic data for Q3 have gotten off to a poor start. July German industrial output fell -0.8% m/m, its third straight monthly contraction, and Spain’s dropped -4.0%.^[i] This brought year-over-year declines to -2.2% and -1.8%, respectively. Meanwhile, eurozone retail sales fell -0.2% m/m in July, leaving them down -1.0% y/y. Then, too, as we discussed recently, August purchasing managers’ index readings seemingly confirmed contraction continued last month. Moreover, leading credit indicators have signaled stalling growth for months. Private sector lending slowed to 1.6% y/y in July and has trailed inflation for two years, suggesting real credit (adjusted for inflation) to the economy has been contractionary.^[ii] M3 money supply is also contracting now.^[iii]

But for stocks, the data are only part of the story. The other part: How do these results align with expectations? On that basis, there doesn’t seem to be much of a surprise here. After the IMF projected German recession last October, GDP contracted for two quarters in Q4 2022 and Q1 this year (with growth flat in Q2), prompting pervasive talk about its earning the “sick man of Europe” moniker. This was as Germany’s widely followed IFO Business Climate Survey hit an October 2022 low of 85.2—which August’s reading recently retested at 85.7.^[iv] (Exhibit 1, green line) Headlines now describe Germany’s “economic rut” getting deeper, with demand “feeble” and the outlook “bleak.”^[v] Attitudes toward the eurozone as a whole mirror those toward its largest economy. After falling for four straight months, the European Commission’s Economic Sentiment Indicator breached its October low in August (yellow).

Exhibit 1: Sentiment Reflects Recession Already

Source: FactSet, as of 9/12/2023. Recession shading based on Euro Area Business Cycle Network dates.

That may seem discouraging, but we think stocks likely pre-priced this year’s eurozone economic weakness last year. (Germany’s, too.) Exhibit 2 shows eurozone stocks hit their lows in September 2022, before Q4’s GDP downturn. They rose thereafter despite Q1 GDP’s second report of -0.1% q/q contraction, which was later revised away.^[vi]

Exhibit 2: Eurozone Stocks Moved Ahead of GDP

Source: FactSet and Eurostat, as of 9/12/2023. MSCI EMU returns with net dividends in euros, 9/30/2021 – 9/11/2023, and eurozone GDP, Q4 2021 – Q2 2023.

Exhibit 3 gives a fuller history of stocks moving before turns in data—and sentiment. In our view, stocks are the ultimate leading indicator, routinely falling before weak data register and, when said weak data hit, rising through the deep pessimism that often follows. COVID’s onset put this in stark relief. Markets weighed the extent of lockdowns’ impact before they showed in the data, then looked forward to the recovery before reopening.

Exhibit 3: Longer View of Eurozone Stocks Moving Ahead of GDP

Source: FactSet and Eurostat, as of 9/12/2023. MSCI EMU returns with net dividends in euros, 12/31/2004 – 9/11/2023, and eurozone GDP, Q1 2005 – Q2 2023. Recession shading based on Euro Area Business Cycle Network dates. Note: Right-hand side y-axis truncated; Q2 2020’s GDP fell -11.5% q/q and Q3’s rose 12.4%.

July and August eurozone data may seem gloomy, but they are backward looking. Weak data now say nothing about where stocks are headed because stocks move most on the gap between future reality over the next 3 to 30 months and present expectations. Currently on the expectations front, widespread eurozone pessimism saps downbeat data’s surprise power. Forthcoming data may prove gloomy, too, but that isn’t likely to sway stocks much when most everyone anticipates it.

Somewhat perversely, though, seeing these dour data can help people move on from their recession fixations, providing a sense of closure. Once it manifests, the implications become visible, and fear loses its power in the light of day. As uncertainty clears, fears evaporate—or at least lose their sting—allowing stocks to ascend bull markets’ wall of worry.

When a big fear like recession accompanies market volatility, it can be hard to shake—especially when it appears verging on fruition. But when the Bad Thing everyone is waiting for happens and folks see it isn’t so terrible—or what was expected—we find people tend to get over it pretty quickly.