Time for Europe to outperform the US?

We look at European and US markets, after a year in which the latter strongly outperformed the former, despite substantial flows into European stocks.

Source: Bloomberg

2017 was supposed to be the year that European stock markets outperformed their US cousins. Investors flocked to the continent, as loose monetary policy and strong economic growth combined to make equities there attractive. However, in the end, the US still won out with a return of around 22% for the S&P 500, versus 11% for European indices (admittedly a still very respectable performance).

Certainly, European markets still have plenty of attractions. The political landscape now looks much more encouraging, thanks to the French and German elections being out of the way. While we still have Italy to worry about, and Catalonia too, there is a sense that investors will spend less of 2018 worrying about politics than they did in 2017, as the populist tide retreats.

Real gross domestic product (GDP) is forecast to rise by 2.1% in the eurozone in 2018, and with consumer confidence on the up, and unemployment on the way down, European companies should see the benefit of increased consumer spending. This will feed through to improved earnings per share (EPS), boosting the attractiveness of European equities relative to other parts of the world and relative to fixed income.

A key part of the thesis is that Europe remains cheap, in comparison to the US. After a long rally in equity markets around the globe, no one market can be described as ‘cheap’. However, the game in markets is not to look for absolutes, but to judge markets in relation to others. A forward price-to-earnings (P/E) ratio of 15 for the Stoxx 600 index (the handy benchmark for European stocks) is not exactly bargain-basement territory, but compared to the 18 times for the S&P 500 it is much more attractive. The price-to-book (P/B­) ratio of 2 for the European index is also likely to arouse much more investor interest than the S&P’s 3.4.

There is one problem with the attractiveness of European equities. To buy European stocks, you need euros. And so investors around the world have been buying the euro, which causes EUR/USD to rise. A rising currency tends to limit stock market performance, and anyone who has tried to ride the trend in European markets will confirm this. While the S&P 500 is up 15% over the past 12 months, the EuroStoxx 50 is just 1.8% higher, with the US index leaving its European counterpart trailing far behind over the past three months (up 4.6% versus a 5% drop for Europe).

European equities do offer some compelling fundamentals, but investors here should be aware that the sector has seen substantial flows in the past year and yet has not done as well as the US, which continues to be the standout performer. In reality, most people will have exposure to both, so will reap the benefits of both, but those aiming to pick one or the other should be mindful of the adage that, ‘in bull markets, you buy the strongest performer’. That would still be the US, with the growth-focused Nasdaq still leading the way, having gained 116% over the past five years overall, and 133% for the Nasdaq 100, versus 72% for the S&P 500.

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