Episode notes
Strategists Thomas Mucha and Nick Wylenzek discuss the regime shift in European markets, focusing on deglobalization, tighter monetary policy, and increased government intervention. They explore the impacts on sectors like defense, energy, and the evolving relationship with China.
Key topics:
1:45 - Unpacking the European economic regime shift
7:00 - Alpha potential of European markets
9:15 - National security concerns among EU governments
12:50 - A potential NATO split?
15:20 - Sector outlooks for European equities
16:45 - Europe and China relations
Transcript
Nick: But if you look at the big European sectors within, you look at industrials, you look at consumer discretionaries. You look at part of the pharmaceuticals space. You look at the autos. All of them benefited from globalization, from increasingly complex supply chains, from exporting to, to the growth markets of this world. And their business model is increasingly challenged. And it's becoming more, more difficult.
Thomas: Of all the reverberations from the Trump administration so far in 2025, redrawing the geopolitical chessboard, particularly with respect to Europe, may be the most fascinating. It's also one of the most consequential shifts for investors who have been focused on strong U.S. growth and markets. So how will a fraying transatlantic alliance and a potential global trade war affect Europe? How will the trajectory of the war in Ukraine impact sectors like energy and defense? And what might a warmer European relationship with China actually mean? Joining me to discuss the evolving geopolitical backdrop and its impacts on European markets is Nick Wylenzek, a fellow strategist on our macro team. Nick is an expert on Europe and focuses on thematic research. He's also a close thought partner of mine at the firm. Nick, thanks so much for being here today.
Nick: Thank you, Thomas, it's great to be back.
Thomas: So, Nick, in a recent note you sent out to Wellington investors, you said that we're in the midst of a regime change for European equities, on par with 2008 global financial crisis. So, I'd like to unpack that idea a bit and then delve into a few key areas and themes that you think investors should be paying attention to here. So, to start. What's driving this regime change, as you call it?
Nick: Yes. Thank you for the question. Let's start with what Europe was. In the decade after the global financial crisis, you would classify Europe as a region with low domestic demand, low inflation, and low rates. This benefited in particular international growth stocks. However, I believe when I think about the next ten years, Europe is going to be a region with stronger domestic demand but also higher inflation and higher rates. And I think there are three drivers of that. So, first of all, I think we are seeing increasing deglobalization and trade tension, which relates are which drives a more fragmented world. So being international is no longer a positive for European companies. I think we are also seeing a shift in monetary policy. I think monetary policy is going to be structurally tighter. And I think policymakers in Europe are shifting their focus more domestically, from a national security angle but also from a domestic growth and energy independence angle.
What does it mean for Europe? I think as I said before, I think we're going to see higher inflation, higher rates. I think we're going to see increased political intervention. I believe valuations will matter again. I think international exposure is no longer a clear positive. And I think new leaders will emerge similar to 2000, 2008 when we saw a bigger shift in market leadership.
Thomas: So big reversals for Europe. You've mentioned a lot of things. Let's unpack those one by one. Nick. Starting with deglobalization and trade. Now, obviously, as you say, Europe's open economy, you know, makes it sensitive to tariffs. But are there certain countries or companies here that could either, you know, fare worse or perform better than expected in the event of a prolonged, trade war between Europe and the United States?
Nick: Yes. And I wouldn't just focus on the United States and Europe. I also look at Europe and China and the global, trade picture more holistically. But if you look at the big European sectors within, you look at industrials, you look at consumer discretionaries. You look at part of the pharmaceuticals space. You look at the autos. All of them benefited from globalization, from increasingly complex supply chains, from exporting to, to the growth markets of this world. And their business model is increasingly challenged. And it's becoming more, more difficult. At the same time, the losers of the last ten years, the domestically focused stocks, they're looking much better if we if I'm right, we're seeing domestic demand pick up — that benefits this part of the market that has been neglected for so long.
Thomas: Sort of a fortress Europe, situation?
Nick: Yes, exactly. And that that involves, for example, the European periphery that's very domestically focused compared to, for example, the German stock market. But also benefit small caps, more general; a part of the market for a long time neglected trading relative to large cap at the cheapest they've traded in 30 years. And that's another part of the market that's structurally much more domestic and should benefit from the trend.
Thomas: So on your second point, Nick, about tighter monetary policy, you know, there's a connection here. What impact will higher rates and a structural shift in inflation have on those companies and on the broader market backdrop in Europe?
Nick: For the decade after the financial crisis, policymakers in the US and Europe did not have to worry about inflation at all, which allowed them to solve monetary policy in favor of growth. Going forward, I think there's a bigger trade off to consider — demographic change, geopolitical tensions, limits to immigration, more fiscal spending should result in structurally higher inflation, which will require stricter monetary policy. What does it mean for markets? I think the two conclusions here. So, first of all, for a given level of growth, equity returns are likely to be lower than in the decade after the financial crisis. So, structurally higher, tighter monetary policy and structurally lower equity returns. And second, as I hinted earlier, valuation will matter again if money is no longer free, investors will no longer buy growth and long duration assets at any price. And I think that's something the market so far has been ignoring. When you look at the valuation of European growth stocks relative to value stocks, they're still trading at a record-high premium, higher than during the tech bubble. Because growth stocks were the winners of the old regime, the international companies that benefited from lower rates. Value stocks are likely to be the winners of the next regime with stronger domestic demand, but also higher rates.
Thomas: Do you think this is going to produce a lot more differentiation in either growth or value sectors, and therefore is a positive for actively managed strategies?
Nick: Yes, definitely. I think that the alpha potential in Europe is extremely unique at the moment. And the opportunity set for active managers is probably the best in in over a decade.
Thomas: Of course, you have to know where to look. And you mentioned energy and infrastructure earlier Nick, which to me is a good segue to your comments about government intervention. So, from where you sit in London, what are the policymakers’ chief goals here across Europe? I mean, can you give us a couple of examples of how this structural, policy-level shift is coming through from an investment perspective?
Nick: I think there are two priorities for European policymakers. One is national security, a topic, that has been in the US, always top of mind for a long time in Europe became more important only recently. And the second one is competitiveness. And to kind of achieve their goals in these two areas, they are focusing on three big themes.
So, first of all, defense — clearly national security you need to spend more on more defense. Secondly, energy security and independence. I think that's overlaps in both national security and competitiveness because you need to ensure sufficient energy supply. But you need to also make sure that energy is cheap enough for European companies to be competitive. And then, thirdly, digitalization, I think that's another big topic European policymakers are focused on. Here competitiveness is the slightly more important angle. But to give you a statistic, more than two-thirds of German companies are still using a fax machine. So, you can see there's really a lot of room for digitalization and an improving competitiveness by that way.
Thomas: So, Nick, you just mentioned national security. So you're veering dangerously close into my area of interest here. As we both know, it's a very short walk a focus on domestic economic strength to a focus on domestic military strength. But before we touch upon the market implications. What's your view on Europe's ability to ramp up its defense capabilities? And how are the policies working here to provide a tailwind for a potential rearm Europe movement?
Nick: First of all, I would say there's a very large willingness to rearm Europe. I think that's driven by two things. One, of course, the developments in Ukraine, the threat of Russia. On the other side, the current US administration slowly pulling out of Europe and Europe having to do a bigger share of its own on defense compared to what it did in in the past.
Now that I think there are two ways to approach that. There's Germany and there's rest of Europe. Germany is in the lucky position that it has a lot of fiscal flexibility. Government debt to GDP is 64%. That's by far the lowest of the G7 countries. Now, with the new government in place in Germany, we've already seen quite significant changes in the sense that the debt brake has been amended in a way that the defense no longer is part of the debt brake, allowing the government to spend unlimited amounts, in theory, on defense. And I think there's a big movement that we're going to see significant spending over the coming years. Now, looking at the rest of Europe, unfortunately the fiscal flexibilities just aren't there. If you look at countries like Italy, France, Spain, they have a lot less fiscal headroom to play with. So that's where the EU is stepping in. We're increasingly seeing talks about the EU allowing for neutralized debt to finance defense spending. So, it's a basically a further development of Europe's Hamiltonian moment during the Covid crisis when they, for the first time, really neutralized debt to finance the Covid response. Now, it's potentially utilizing debt to finance defense spending. And that allows other countries out allows other countries to spend more on defense, as well, without having the same fiscal headroom, and also leads to more European integration.
Thomas: It's often the case in history where crisis forces governments into a do-whatever-it-takes moment. It's what it certainly feels like in Europe when it comes to national security. I'm also curious on your views, Nick. In my circles, I hear a lot about a couple of things. One, the potential use of, French and UK nuclear weapons to provide an umbrella to maybe move in and replace the United States. Are you picking up on that from, your contacts across Europe?
Nick: Yes, there's certainly, a lot more talk about that. There's a lot more talk about, at, coordinating European defense capabilities, especially in a certain area where the US is no longer seen as a reliable partner. And, in that environment, nuclear defense capability is, of course, a topic that's discussed as well. But of course, I think that would really need another big step change in sentiment for that really to progress. I think there are a lot of other steps European administrations can take to better coordinate defense capabilities without going towards a more basically nuclear rearmament of Europe.
Thomas: Right. The way I hear that described as sort of using that umbrella as a way to give Europe more time to build up its own defense capacity. But, you know, it's part of this more rapidly shifting geopolitical backdrop that's leading to more radical policy ideas. The other thing that I hear a lot about Nick, in my contacts with national security policymakers, I mean, they're frankly and openly discussing the ramifications of a potential NATO split. And I'm curious, how do you factor that into your scenarios here? And do you think that there's on the other hand, a potential for the alliance to become itself more muscular and more united as members continue to ramp up defense spending?
Nick: I think a lot here will depend on the true intentions of the US administration. If Trump is using his talk about potentially pulling out of NATO purely to put pressure on European governments to spend more, then I think we can come out with a stronger NATO because European countries are really stepping up the defense spending. And we went from a few years ago, hardly any country met the 2% spending hurdle, to now countries talking about 3% plus as a share of GDP when it comes to defense spending. So if that's Trump's and the US administration's intention, I think, yes, NATO will be more muscular. However, there's of course a lot of uncertainty. And if I think Trump is not fully committed to NATO and article five, I think the alliance will ultimately break apart. And Europe's integration with accelerate... But the new European kind of defense force will be weaker than it was before.
Thomas: Yeah. And then of course, Finland and Sweden are also part of the alliance, too. And so there have been drastic changes in the alliance even before Trump came back into power. You know, the other piece of this, Nick, and you've alluded to it, is the sort of transactional nature that the Trump administration is applying to Ukraine, to US relationship with Russia, and all these potential ceasefire agreements that are being discussed now. I want to bring it back to the markets here. And if we do get a ceasefire, if we do get something that's more durable, how is this likely to impact European defense stocks, at least in the short term?
Nick: Well, if you had asked me this question six months ago and I said, what would a peace deal do to European defense stocks out of said they would probably sell off on the back of it. It might not change the structural picture, but in the short term, defense still is negative for European defense stocks. However, everything we know, or will be learned over the next few months, suggests that any potential defense deal, so any potential peace deal is going to be very unstable and the threat of Russia to Europe remains. And I think that will lead to defense stocks probably not selling off as much, and the kind of the defense super cycle continuing over the coming years.
Thomas: So that sounds to me that you are, broadly speaking, top-down bullish on European defense firms and energy utilities. But are there other bottom-up caveats to consider here, sector by sector?
Nick: Yeah, I would say if you if you think about Europe, Europe used to be about international growth companies, the luxury goods companies, the auto manufacturers, the industrials. The new Europe is around domestic demand, fiscal spending, more political intervention. Which are the sectors that are going to benefit from that? And as you said, defense is clearly one of them. I think the European banks would benefit from that. I think parts of utilities will do well. I think the European telcos will probably do well. And I also think European small caps will do well. So, it's a very different set of companies, it’s those focused domestically that benefit from the changing policy priorities.
Thomas: Yeah, that's quite a regime shift. And Nick, we can't escape the elephant in the room here, which, of course, is China. And I do think the Chinese government probably sees any rift between the US and its European allies as an opportunity to exploit, rightly so. Realpolitik would suggest enormous upsides for Beijing — economic, diplomatic, otherwise — if China can improve relations with Europe. So, how are you thinking about, broadly speaking, China as a competitor for Europe, or is it a customer, a supplier, an ally, an adversary? How does China fit into this increasingly complex geopolitical and economic puzzle?
Nick: It's really all of the above. So, when you think about Europe, it's still an open economy. So even if domestic demand picks up, it still needs to export its goods. With the US market potentially harder to access because of tariffs, China remains a very important trading partner for European companies and European countries. So that's the first part. But I would say that Europe will be very careful in separating sectors where they see some strategic importance. Those are sectors they will shield from Chinese competition and Chinese influence. And there are other sectors where they'll very happily trade with China. They're very happy to invest in China, but they also are very happy to see China investing in in Europe. One example, the auto space. I mean, we're seeing BYD now opening a manufacturing plant in the EU. I think this was unthinkable a few years ago, but European policymakers want to see some Chinese investments in Europe, and autos are not seen as a strategic sector. Take the other side, defense stocks. They will be heavily shielded from any kind of Chinese influence and competition. So, really depends on where a sector falls in this separation between strategically important a matter of national security and the part where Europe still wants to have an open economy.
Thomas: How are European policymakers viewing the China Russia relationship? Because you mentioned earlier that Russia is one of the key driving factors in European defense thinking. If Russia and China continue to remain allied, how will that impact Europe's position regarding China?
Nick: Yeah, it's obviously a very difficult situation. It will be very difficult, for kind of European policymakers to strike a balance here. But I've heard now several times that European policymakers see China as a way to put pressure on Russia, or put influence on Russia. Allowing China to do business in Europe, allowing Chinese business to invest in Europe, but at the same time, European businesses investing in China and using that as a way to influence the Chinese government to potentially put some influence on Russia, especially if Chinese troops might have some peacekeeping roles in Ukraine, having a friendly relationship with China is very important for European governments.
Thomas: Well, Nick, you’ve just outlined how complex, transactional, fluid and complicated the geopolitical and policy backdrop is. Thanks so much for taking this time to help us make sense of it through the European lens and this important regime shift that you're detecting. Once again, macro strategist Nick Wylenzek. Thanks for being with us here on WellSaid.
Nick: Thank you very much for having me, Thomas.
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