investment insights
Changing fortunes narrow Europe’s differences
Key takeaways
- Germany and France have underperformed other post-pandemic recoveries in the eurozone. We expect this gap to narrow over the quarters ahead
- We see the European Central Bank reducing interest rates by another 25 basis points this year, reaching a terminal rate, at the end of the cutting cycle, of 1.5% by the end of 2025
- Falling interest rates now favour French and German equities, where earnings expectations are stronger than for Spain and Italy
- In fixed income, we prefer Spanish and German government bonds over French and Italian ones. In credit, we favour French and German corporate bonds.
By most measures, the German economy is struggling. Growth has stalled, its industrial model is challenged and political landscape fragile. You would not guess so by looking at its equity market, which has gained more than 10% this year. Nor from the euro, which remains stable against the dollar. How should investors position their European assets? We set out our views across equities and fixed income.
Since 2021, the EU’s largest economies – Germany and, to a lesser extent, France – have underperformed other member states. Southern economies have benefited from their much higher exposure to the services sector, in particular tourism, and its strong post-pandemic rebound. In addition, economies including Spain, Italy and Greece have much smaller manufacturing sectors, and so suffered less from energy price spikes and high interest rates. This in turn helped them to generate stronger goods and services exports.
These economies also secured EU recovery funding worth around 10% of their gross domestic product (GDP). In contrast, EU funds provided very marginal support for France and Germany – equivalent to around 1% and less than 0.5% of GDP respectively. This is by design. The post pandemic funds aimed to help compensate a lack of fiscal resources, helping Spain, Portugal and Greece outperform their larger neighbours with growth of more than 2% in 2023. France and Italy recorded growth of less than 1% in 2023, and we expect them to do so again this year.
In contrast, Germany’s economy contracted -0.3% in 2023 and is stagnating this year – we expect growth of just 0.1% for 2024. Much of Germany’s growth gap with France and Italy comes from its tighter fiscal stance. Germany’s budget deficit was just -2.5% in 2023, and should be in the range of 1.5% this year, compared with France’s budget deficit of over -5% and Italy’s of -7% in 2023.
We expect this gap between Germany and other European economies to start to narrow next year. Our forecasts project German GDP growth reaching 1% in 2025, while small European economies should slow as the impact of the energy price shock diminishes and the EU’s recovery funding slows.
Despite Germany’s economic contraction last year, unemployment remained stable and other EU states recorded small declines in joblessness. In all cases, unemployment has been lower than pre-pandemic. As a result, private consumption has remained relatively healthy. Looking much further ahead, the region would also of course benefit from any lessening in geopolitical tensions in the Middle East or Ukraine, that could translate into industrial investments.
Conditions more favourable for core EU equities in 2025
European stock market performances have been mixed this year, mirroring their different sector weightings. The Italian and Spanish stock indices have a larger share of financials, where higher interest rates boosted banks’ interest income. France in contrast is weighted to industrial firms, and some healthcare, but has fewer financial stocks. Germany’s export-driven economy makes it sensitive to the euro, which was weaker against the US dollar and other currencies for much of the year, offsetting the market’s sectorial disadvantages. Industrial sector weakness was particularly detrimental to German carmakers and French political uncertainty drove investors from the French market.
Where rising interest rates favoured smaller European economies, falling rates will now create headwinds. Earnings expectations are currently stronger for French and German markets, compared with companies in Italy and Spain. Further afield, any significant policy support for the Chinese economy may help Germany and France, whose luxury and consumer discretionary sectors are exposed to Asia’s biggest market.
France’s new government remains fragile and has very limited room for manoeuvre, with little chance of major legislation passing both chambers of Parliament. This puts more weight on macroeconomic developments and monetary policy as key factors for the French equity market. With the CAC40 down -1% year-to-date – in contrast to the German, Italian or Spanish markets, which have risen by low double-digits over the same period – we see the potential For French equities to outperform Spanish and Italian markets going forward. We also expect further upside for German stocks. Against other regions, we remain underweight European stocks in multi-asset portfolios.
Prefer Spanish and German sovereign bonds, French and German investment grade corporates
Following the European Central Bank’s (ECB) 25 basis point (bps) cut on 12 September, markets anticipate another 40 bps of cuts through the end of 2024. We expect an additional 25 bps of cuts this year, and further cuts to reduce rates at the end of 2025 to 1.5%. This would help short-term euro rates fall relatively more than long-term rates. On a 12-month horizon, we see 2-year and 10-year German Bund yields reaching 1.65% and 2.05% respectively, from their current yields of around 2.2%. The widening spread between long and short-term rates – and a steepening yield curve – strengthens our preference for 5- to 7-year maturities in euro-denominated bonds. This maturity range offers a stronger total return potential from more steeply falling short-term rates than long-term ones.
French sovereign bonds appear cheap by historical standards and compared with German Bunds, but their yields are now mirroring French public debt ratios, which are more in line with Spain’s than Germany’s. We see limited potential for French sovereign bond spreads to narrow based on the likely inability of the French government to pass necessary reforms. Italy’s fiscal picture remains even less attractive while its credit spreads are lower than average. Based on fair value estimates, we prefer German and Spanish government bonds to their French and Italian equivalents.
In credit markets, French and German corporate debt has lagged its counterparts in other European markets, both over a one-year horizon and year-to-date. Most investment grade corporates, regardless of their region, have substantial international reach. That said, Germany and France tend to offer more sector diversification, more appealing spreads relative to Spanish and Italian indexes, and a longer-duration market. That tends to make credit spreads more stable.
In contrast, regions such as Italy and Spain have a higher concentration of financial names, which makes them more sensitive to volatile markets and economic uncertainty. As the eurozone’s monetary policy continues to ease, high quality French and German corporate credit should benefit. In uncertain markets, that should lend resilience and act as a strong falling interest rates now favour French equities where earnings expectations are stronger than for France.
With contributions from Bill Papadakis, Senior Macro Strategist, Edmund Ng, Senior Equity Strategist, and Sami Pepin, Fixed Income Strategist.
Important information
This is a marketing communication issued by Bank Lombard Odier & Co Ltd (hereinafter “Lombard Odier”).
It is not intended for distribution, publication, or use in any jurisdiction where such distribution, publication, or use would be unlawful, nor is it aimed at any person or entity to whom it would be unlawful to address such a marketing communication.
Read more.
share.