The revenge of the domestics
There have been many celebrations throughout the ages where domestic servants have become the equal or even taken the place of their masters – the Roman Saturnalia, certain aristocratic balls in England in the 19th century and the Festival of Fools in the Middle Ages, to name but a few. This is a tradition that European stock markets seem to be looking to update. Since the beginning of the year, the “domestics” – the shares of companies primarily focused on the internal European market – have largely supplanted the “masters” of the last decade, i.e. exporters.
At first glance, this seems sensible:in an environment of trade tensions exacerbated by the US tariffs policy, it seems logical that companies focused on international business should suffer most. However, during the first (US) trade war in 2018-2019 – mainly against China – this was not the case and the trend of outperformance for international stocks versus their domestic peers even strengthened.
In reality, the change in pre-eminence seen since the beginning of the year is based on a combination of different factors. Headwinds are building on a number of fronts for exporters. Donald Trump’s trade tariffs policy is of course the first of these, but it is strengthened by the ongoing weakness of the other major outlet for European exporters – China. Despite the first signs of improvement, consumer demand remains weak in China and is a source of anxiety regularly mentioned, particularly by names in the luxury goods sector, first and foremost LVMH. In addition, exporting companies are also penalised by the strong appreciation of the euro since the start of the year. The single currency has risen by close to 10% against a basket of currencies and against the US dollar. This trend could continue, with the prospect of seeing the EUR/USD exchange rate at around 1.20 (versus 1.13 today) looking quite plausible in a few quarters’ time.
This strengthening of the euro automatically penalises exporters by making European products more expensive. But it also automatically favours certain domestic companies. This is particularly the case for those that have to import massive volumes of raw materials, which are generally traded in US dollars on global markets; the strengthening of the euro versus the US dollar thus increases their purchasing power.
However, the main tailwind for domestic companies is the massive investment plans announced in recent months – in Germany and with the ReArm Europe plan. The consequence of these investments will be to raise potential growth, particularly in Germany, but across the eurozone as a whole, after a decade of continuing deterioration. In the past, there has been strong correlation between the fall in potential growth in the eurozone and the underperformance of domestic stocks versus exporters.
Of course, after the strong catchup seen since the start of the year[1], it is worth asking whether the trend can continue. There are several reasons to feel optimistic about domestic stocks. On the one hand, they are still trading at a substantial valuation discount versus exporting stocks, and this could start to decline. On the other, additional catalysts could appear, on top of the favourable elements cited above. European deregulation – increasingly mentioned but not yet implemented – could be the first of these. A change in consumer behaviour in Europe – where consumption continues to run at a level well below pre-COVID times – would be a second. During the Saturnalia, domestics took the place of their masters for an evening. But on European markets, the revenge of the domestics is set fair to continue.