Is Europe in secular decline? If so, can it be halted? Since as recently as 1990, the region’s share of global GDP has declined from 24% to 14%. Even compared to other advanced economies, Europe has lost ground. Indeed, since 2005 European GDP growth has trailed the USA by 0.7% annually (the gap is less on a per capita basis, reflecting the area’s relatively stagnant population growth). That might not seen like a lot, but it amounts to a cumulative 10% underperformance during this relatively short interval.

Reflecting these trends, European equity markets have lagged the S&P 500 over virtually any chosen interval. Can these unfavorable trends be reversed? In the near term (1-2 years), quite possibly. Indeed, I have been recommending investors overweight Europe in recent years: during the past 3 years, European stocks have finally kept pace with the USA. And, despite 2023’s underperformance, I stick with this tactical view. Longer term, however, deep-seated reforms aimed at boosting productivity, particularly in the technology, energy, and service sectors, will be required to address Europe’s secular decline and to restore investor optimism on a strategic basis.

Playing Catch-Up in 2024?

Reflecting Europe’s economic underperformance, the region has lagged far behind the USA during the post-Covid recovery (Chart above). The gap was especially pronounced in 2023; when Eurozone GDP trailed by almost 2%. However, it’s worth noting that the region’s performance has not been uniform: Scandinavia and Eastern Europe have enjoyed stronger rebounds than France, Germany, and the UK. But, even these healthier economies stalled last year.

The composition of post-Covid activity is also revealing. America’s outperformance has relied heavily upon surprisingly resilient consumer spending, especially compared to Europe. On the other hand, Europe’s external sector has contributed positively to post-Covid GDP, as exports have been ok. Meanwhile, the US foreign sector has been a drag: weak exports combined with strong import demand.

After years of lagging, I expect EU GDP growth to match the USA’s in 2024 at least: both expanding an admittedly meagre 1-1.5%. One reason is that I expect US consumer spending to cool, as the Covid windfall has now been exhausted. In Europe, on the other hand, excess savings remains high, which should support household outlays as inflation declines (Chart above).

Manufacturing: Energy Transition Progressing

The particular weakness in Europe’s manfacturing sector — industrial production contracted 3% last year — has led to speculation the region may have a chronic competitiveness problem. Fortunately, neither recent export trends nor real exchange rate values point in this direction. Rather, EU industry is primarily coping with the shock of higher energy prices and the transition away from Russian supplies.

Fortunately, there’s relief on both fronts. The Chart above illustrates Russia’s share of EU oil imports has collapsed from 28% to 3% during the past two years. Similarly, Russia now accounts for less than 12% of natural gas imports compared to 40% in 2021. There’s still more work to do, but the most intense period of adjustment may be accomplished. Likewise, natural gas prices in Europe have declined sharply from the peak; bringing relief to the region’s industry and consumers. Nevertheless, Europe is still at a competitive disadvantage: NG quotes remain 30% higher than before the Ukraine war, while those in the USA are 30% lower.

Regarding the energy transition, the European Union has a long way to go to meet their ambitious climate goals. Indeed, emissions per capita have not declined much since before the pandemic. Nevertheless, the region is considerably better positioned than the USA and other regions (Chart above).

Macro-Policy: A Bit More Room to Maneuver

I’m optimistic inflation will decline in both the USA and Eurozone in 2024/25. However, I expect the ECB will achieve its 2% target before the US Federal Reserve. Indeed, Eurozone inflation may approach the goal before the end of this year. First of all, given Europe’s weaker post-Covid rebound, the region’s economy has more spare capacity. For example, despite impressive recent declines, Europe’s unemployment rate exceeds US joblessness: 3.7% versus 6.4%.

Likewise, while both areas have enjoyed surprisingly robust labour market performance, Europe’s labour supply response has been even more impressive. In particular, the area’s labour force participation rate has risen sharply, while the US rate is still below pre-Covid levels (Chart above). To be sure, the ECB will remain concerned about the region’s 5%-plus wage growth, but I expect pay gains will cool in the next two years.

As a result, I expect both the ECB and the Fed will begin lowering interest rates this Summer. The difference, however, is the Fed’s pace of easing is likely to disappoint markets. Meanwhile, investors may be positively surprised if the ECB cuts rates to 2.5% by mid-2025, as I anticipate.

On the fiscal front, post-Covid government debt levels are higher in all countries (Chart above). Overall, however, Europe’s burden is lighter than the USA. Therefore, the EU is better positioned to meet future supply-side spending needs (climate/infrastructure), to respond to further economic weakness, and to fend off potential attacks by bond market vigilantes. Of course, Europe is not uniform: France, Belgium, Italy, and the UK are weak links.

Secular Decline: Reform Vital

Demographics Require Immigration Reform

So that’s the good news. Of course, a key factor in Europe’s secular slump has been decline in the region’s labour force, resulting from its low birth rate (Chart above). Worth noting, in particular, is the gap between the EU’s labour shortages compared to the USA — which explains much of the recent difference in overall economic performance. Again, Europe is not monolithic: Ireland, Sweden, Norway, and even the UK enjoy solid gains in working-age populations. On the other hand, Germany, Poland, Greece, Italy, and the Baltic countries have the most worrisome trends.

Immigration reform is a potential solution. Foreign-born residents account for roughly 15% of the overall population in both the EU and USA. However, the share differs widely amongst European nations (Chart above). Higher levels of immigration could have a meaningful impact on labour supply in labour-short countries, such as Italy, France, Poland, Portugal, Greece, etc. The current political climate, however, does not suggest reform is likely in the near future.

Solving the Productivity Puzzle #1: Service Sector Deregulation

With labour supply contracting, Europe’s future economic prosperity will rely heavily on productivity improvements. All advanced economies, however, have experienced tepid efficiency gains in recent decades, especially following the Global Financial Crisis (Chart above). Noteably, European output per hour growth has not only decelerated, but has lagged behind the USA, especially since 2010.

Of particular concern, European efficiency gains in the vast service sector, which accounts for over 60% of output and jobs — have lagged far behind the USA for decades (Chart above): US improvements have been four times higher than Europe’s during the past 20 years. Europe’s deficiency is most pronounced in the vital, rapidly-growing information and communications services segment.

High levels of service sector regulation have played and important role in the underdevelopment and poor performance of this portion of Europe’s economy (Chart above). Therefore, deregulation, especially in technology-related services, will be needed to compete in these important areas in the future.

Solving the Productivity Puzzle #2: Technology

To be sure, like everywhere, European capital spending could be higher. However, Europe’s productivity problem does not appear to emanate directly from chronic underinvestment relative to other nations,e.g. capex/GDP is similar to the USA (Chart above).

However, Europe does underinvest significantly in the growth industries of the future. In particular, information and technology investment in most countries lags far behind the USA (Chart above). While Amazon, Google, Microsoft, Tesla, Alibaba, Tencent, etc. are household names, the general public would be hard pressed to come up with world-class European technology companies (they do exists, eg. ARM, Novo Nordisk, etc).

Similarly, research and development expenditure lags well behind the USA, again particularly in the ICT segment (Chart above). Likewise, ICT financing is hampered by Europe’s underdeveloped venture capital market (following Chart).

Strategic Implications

• I expect European equity markets to outperform during the next 12-24 months. Near term, the growth gap with the USA should narrow, and inflation and interest rate declines may surprise more than in the USA.
• Europe enjoys a comparative advantage in certain key sectors, e.g. alternative energy. However, extensive deregulation and greater investment in technology and service industries will be needed to compete with US powerhouses, and halt Europe’s secular decline.
• European markets should trade at a discount to the USA, reflecting a lower return on investment. However, European markets appear relatively inexpensive compared to the USA at present, and the valuation gap should narrow in the period immediately ahead (Chart below).