European Equities Outlook for 2024 and Into 2025

European Equities are faced with the prospect of a mild recession, but less valuations strains than U.S. equities.What is the outlook in 2024 and into 2025?

While EZ corporate earnings hopes for 2024 will likely be trimmed by a sluggish economic outlook, ECB rate cuts and relief that inflation is falling back to 2% should help to produce a rise in price/earnings ratios and see EZ equities gaining 8-10% in 2024. The outlook for 2025 should be constructive as well, as we see a further 100bps of ECB rate cuts. If Donald Trump is elected U.S. president then geopolitical risks could be issue for EZ equities in 2025.

Figure 1: German 12mth Forward P/E Ratio and German 10yr Real Bund Yield Inverted (%)

Source: Datastream/Continuum Economics (using 10yr breakeven inflation expectations)

European equities rebounded in H1 2023 but have stalled in the last three months, as the risk of an EZ recession has been discounted. Are European equities now cheap enough to survive a mild EZ recession of the type we are forecasting (here)?

The German 12mth forward P/E ratio is below the average of recent years, but then we have undergone a major shift in real yields (Figure 1). Using 10yr breakeven inflation expectations, 10yr real Bund yields are now marginally positive rather than the negative real rates seen since the start of ECB QE in 2015. Though we see the ECB cutting policy rates by 75bps in 2024 and a further 100bps in 2025, policy will likely only shift back towards neutral not below. Combined with ongoing APP QT, this will likely mean that 10yr Bund yields only fall to 2.4% end 2024 and 2.35% end 2025. The era of ultra-low bond yields has gone.

Figure 2: Forecasts for ECB Deposit Rate, 2yr and 10yr Bund Yields (%)

Source: Continuum Economics

However, the 12mth forward P/E ratio versus 10yr real Bund yield is not out of line, in contrast to the overvaluation of the U.S. equity market (here). Looking at EZ dividend yield to 2yr Bund yields (Figure 3), 2yr Bund yields match dividend yields for the 1^st time since the GFC. However, as ECB easing starts this will likely bring 2yr yields back down. Meanwhile, 10yr earnings yield for the German equity market continue to remain comfortably above 10yr Bund yields (Figure 4).

Overall, valuations for German and other major EZ equity markets are not super cheap, but are either on the cheap side (12mth forward P/E ratio, earnings yield to nominal 10yr Bund yield) or fair (12mth forward earnings yield to 10yr real Bund yield). What about the 2024/25 economic recovery prospects and corporate earnings?

Figure 3: EZ Dividend Yield and 2yr Bunds (%)

Source: Datastream/Continuum Economics

Figure 4: German Earnings Yield Versus 10yr Bund Yield

Source: Datastream/Continuum Economics

Our concern for European equities is that the 2024 recovery will be weak and we are below consensus at +0.3% for EZ GDP growth. The ECB tightening has been aggressive and has been amplified by APP QT but also by the large runoff of long term repos that has significantly reduced the ECB balance sheet. Money and credit growth point to a tough 2024 (here), with risks that the recession could be worse than the mild two quarter recession we are forecasting in H2 2023.2024 bottom up earnings expectations of 6% for the DAX will likely not be realised and could be trimmed. Could the ECB rate cuts be a catalyst to help the German and EZ equity market?

The ECB has had two noticeable easing cycles in 2008-09 and 2001-03. In both cases, rate cuts helped ignite an equity rally with a delay, alongside economic recovery feeding in. While the backdrop to 2008-09 was exceptional, 2001-03 (Figure 5) was a more normal recession and easing cycle in the EZ. The German equity market rallied from spring 2003, some two years after the ECB starting easing! However, 2000-01 had seen a 20 plus P/E ratio for the German equity market and the 2001-02 was dominated by a structural derating of the market (after the dot.com bust). Since a structural derating has already occurred in 2022, our forecast of 2024 ECB rate cuts will likely translate into an increase in the price/earnings ratio and we can see Germany and EZ Equities having 8-10% upside in 2024 on this multiple rerating story. This will likely only match U.S. equities next year, as we forecast 4800 for the S&P500 by end 2024.

Figure 5: ECB Deposit Rate and Dax 30 Yr/Yr Change (%)

Source: Datastream/Continuum Economics

For 2025, the ECB rate cuts should help to progress growth towards trend (circa 1.3%), which will help the earnings outlook. Additionally, EZ fiscal policy will remain supportive to growth via the EU Next Gen funds and the European green deal. Though some EZ government at a national level will plan some fiscal consolidation, this will be secondary to the wider EU policy thrust.

Two risk factors for EZ equities are national government fiscal policy and ECB PEPP QT. If a major EZ government plans too loose fiscal policy (e.g. Italy) this could cause a mini fiscal crisis, which prompts divergence within EZ equities but potentially also caps overall equity market performance. We are not just concerned with Italy, but also are watchful of Spain and France, given their primary budget deficit/GDP trajectories. We have also highlighted that France is vulnerable after the huge debt build up since 2007 (here), which is unlikely to be repeated over the remainder of the 2020's. Meanwhile, the other issue is whether the ECB goes ahead and starts PEPP QT from January 2025. Our bias is that they will delay this once the rate cut cycle is underway.

The other swing factor is the Ukraine war. We feel that we are entering a frozen conflict (here) and the chance of a credible peace deal that reduces Russian sanctions and derisk European geopolitical risk remains low, while President Vladimir Putin remains in power .On an interrelated basis is the outcome of the November 2024 U.S. presidential election. A re-elected Joe Biden would maintain the current policy and support for Ukraine and opposition to Putin. A Donald Trump victory would create uncertainty for EZ equities. Trump has said he would end the Ukraine war swiftly, which is assumed to mean reduce financial and military support for Ukraine and forcing a peace deal with Russia along current military lines. This would be strongly opposed by the EU and cause major tensions with the U.S. Also Trump advisors have also been asked to look at the option of withdrawing the U.S. from NATO in future years, which would create long-term uncertainty for European military security.

For 2025, the economic and monetary policy backdrop should be positive for EZ equities (a further 7-10% upside) to build on 2024, but the geopolitics could either be neutral or negative.