It has been taken as given that the Iran war has been economically worse for Europe than for the US, as the former is an energy importer while the latter is an exporter.
By Daniel Morris, Chief Market Strategist
From a GDP point of view, this is certainly the case. Net exports should improve for the US and deteriorate for Europe.
But the effect on business activity and consumer demand is not necessarily different. It does not matter to a business or an individual whether their now more expensive energy was imported or produced domestically.
The price increase for Brent oil (the benchmark for Europe) has indeed been greater than that for West Texas Intermediate (WTI, the US benchmark), but not dramatically so. The Brent ‘premium’ (how much Brent oil prices have increased compared to WTI), has averaged just 7% over the last two months, though for a few days it topped 20% (see Exhibit 1).
This premium, however, does not seem to be sufficient to cause a significantly greater weakening of the European economy. In fact, one could argue the impact of higher energy prices could be larger on the US.
The average US motorist drives around twice the number of kilometres per year than a European driver. In addition, transportation costs represent a higher share of service sector costs in the US than in Europe, due to the greater physical size of the market. On the other hand, manufacturing represents a larger share of the economy (15%) in Europe than it does in the US (10%).
Regardless of what one might believe should be the impact, Purchasing Managers’ Indices (PMIs) show that the European economy is weakening more than the US.
While some manufacturing sector PMIs somewhat surprisingly improved in March and April (partly due to higher supplier delivery times, which is interpreted as positive in the index calculation as it may indicate greater demand), the flash figures for May dropped into contractionary territory for Germany and France, while the PMI improved in the US (see Exhibit 2).
The deterioration in the services sector PMI was immediate and more dramatic, though the impact of higher energy prices on services should be less than for manufacturing.
European PMIs have fallen an average of five points and all the readings are below 50, indicating contraction. In the US, there has been a deterioration of less than two points and the PMIs remain in expansionary territory.
The final arbiter as far as equity investors are concerned is the market itself, and it has delivered a similarly damning judgement. Since 27 February, European equities have underperformed US value stocks (using the Russell 1000 Value index instead of the S&P 500 to measure the performance of the US market in order to make an ‘apples to apples’ comparison as far as sector composition is concerned; the S&P 500 has performed better than the Russell index, but this reflects the recent global outperformance of technology shares, which make up only a small part of the MSCI Europe index).
Despite the recovery in equity markets since the end of March, the return for MSCI Europe since the start of the war is still negative while Russell Value is more than 5% higher (see Exhibit 3).
The underperformance of European equities is nothing new, but blaming it on the Iran war may be mistaken. The structural challenges the region faces, and the arguably greater dynamism of US companies, is a more likely explanation.
A better option for investors looking for exposure to the region may be to focus on industries which may benefit from initiatives to support Europe’s ‘strategic autonomy’. This project addresses deficiencies not only in the defence sector but also looks to boost capabilities in healthcare and energy resilience, for example.
The potential investment opportunity is clear as investors can effectively monetise government spending since funding to support the initiatives goes primarily to companies. The offsetting factor may be higher government bond yields if debt turns out to be the primary source of the additional spending.
