Why Laggard European Stocks Will Overtake Tech-Fueled US Equity

Art by Chris Buzelli

Stock investments in the New World have beaten those in the Old World handily since the 2008-09 financial crisis. But get this: US equities could well lag behind in upcoming years, as staid Europe shows up those American upstarts. Take note, asset allocators looking for offshore opportunities in the future.

For the past dozen years, the investment laurels decorated American brows. “Europe has lagged because of the composition” of its equities market, said Jamie Carter, manager of F/m Investments’ European L/S Small Cap fund. Namely, US stocks are dominated by fast-growing tech names, such as Apple and Amazon, while Europe’s market leaders feature stodgier consumer goods, health care, and industrials.

In volatile 2020 thus far, the S&P 500 is down just 3.5%. Among the major European Union nations, as of last week, all except industrial powerhouse Germany (minus 7.4%) are down by double digits. The worst hit is Spain, whose index is 23% in the red. The overall Stoxx Europe 600 benchmark has lost 12.8% from year-end 2019.

US Stocks Continue to Clobber Europe’s

*Through June 19
Source: Dow Jones Market Data

Just the same, over the past month, amid a worldwide rally from the March lows, the pan-Europe index has advanced 11.5%, versus 5.5% for the S&P 500. Reason: In response to the pandemic, the previously squabbling eurozone nations have united in pushing for both fiscal and monetary measures to right their economies. While Washington has enacted its own ambitious rescue program, the US has other problems that may lead to market underperformance.

The case for Europe is well presented in a research paper from Pavilion Global Markets, a Montreal research firm. “The U.S is oscillating between social distancing and rioting, while President [Donald] Trump is upping the rhetoric against China, and facing an election schedule that makes working across the political aisle more difficult,” the analysts wrote.

“In contrast,” the report continued, “Europe is emerging from the COVID-19 lockdown, and, oddly, there is growing broad political support for more fiscal spending, which should help put a floor under economic conditions.”

In addition, a report from Barclays said, European stocks should gain ground since they are relatively cheap, and skyrocketing US tech can’t keep ascending forever.

For pension funds and other institutional investors, a healthy dollop of international equities adds needed diversification. Through 2019, when US stocks smoked the rest of the world, their American allocation grew slightly more, rising to 47% of equities from 44% in 2018, says Wilshire Associates. Still, continued robust numbers out of Europe might re-tilt that balance.

So let’s look at the case for underweighting Europe, and then at the opposite alternative:

Europe’s Faded Glory

The US stock market has been alluring for years. Investing in equities has for a long time almost been a religion in the US, which is reflected in the size of its bourses, and gives American investors more opportunity to bid up shares.

The combined market value of Europe’s major exchanges right now total $2.3 trillion, according to Statista. The New York Stock Exchange has a market capitalization of $25 trillion, and the Nasdaq weighs in at $11 trillion. That disparity in market cap is owed to greater American reliance on equity, where the Europeans prefer debt as their capital vehicle of choice, often from banks.

The last time European stocks outperformed American ones on a sustained basis was in the 1980s, by almost a full percentage point, 12.7% annually for Europe, 11.8% for the US, by the count of the Global Financial Database.  This was before the ascent of US technology. The turn-of-the-century dot-com implosion that rocked the States was a non-event in Europe. Hence, between 1999 and 2002, European stocks did better.

Since then, it has been USA all the way. First came the market fuel that the housing craze furnished. And after the 2008-09 global financial crisis, the US remained the best avenue for returns. A big reason is that the US, which pulled out of the Great Recession first, has been the refuge haven, as Europe got pole-axed again a year after the recession ended.

Starting in 2010, Europe descended into the sovereign debt crisis, where its southern tier nations (Spain, Portugal, Italy, and especially Greece) couldn’t service their staggering borrowings. Germany, the continent’s largest economy, didn’t want to bail out these profligate countries. The European Central Bank (ECB) eventually came to the rescue with massive bond buying. Dismayed by the mess at home, multitudes of European investors channeled their money into the US.

Over the 10 years ending last December, US stocks averaged a 14.1% annual return versus European shares at 3.2%, MSCI stats show. The downward drag of the European debt imbroglio demolished the continent’s recovery from the financial crisis. In 2011, the worst year for the debt debacle, American stocks were held to a 2% advance, while Europe’s lost 11%. That entire decade, US shares beat Europe’s every year except one, and the margin was usually large.

Average return on equity, a measure of financial performance, is 14% in the United States and 10% on the other side of the Atlantic, pointed out Elizabeth Desmond, deputy CEO and CIO of Mondrian Investment Partners. Plus, “the US took on lots more debt,” she added, which helped stocks.

And how. U.S. corporate debt (not including financial companies) expanded by more than half since 2008 to over $10 trillion, a record 47% of gross domestic product, says the St. Louis Federal Reserve Bank. A good chunk of that went to buy back stocks, which further goosed share prices.

Turbocharging US stocks are the tech superstars, which mint earnings and are at the center of American economic superiority over the rest of the world. Of the top 10 domestic companies by market cap, the first half is composed of the tech giants: Apple, Microsoft, Amazon, Google, and Facebook (FAANG without Netflix).

The equivalents in Europe, by consulting/accounting firm PwC’s count, are in far less dynamic fields: Nestle (consumer goods, Switzerland), Roche (health care, Switzerland), LVMH (luxury items, France), L’Oreal (cosmetics, France), and Novo Nordisk (health care, Denmark).

European tech has been far back in the pack. Look at Finland’s Nokia, which in 1998 reigned as the world’s best-selling cellphone company. Then this has-been computer maker named Apple took its crown.

Helping to plump up American earnings is that the US public spends more and is willing to finance the purchases with credit cards. “European consumers don’t spend like Americans,” said Cameron Brandt, director of research at EPFR. In addition, this nation’s bankruptcy system “allows the market to clear quicker” of doddering companies, he observed. “The US practices savage capitalism and then goes roaring back” to profitability.

The old saw is that Americans live to work and Europeans work to live. The continent’s joie de vivre may become even more joyous if the market leadership passes to it.

American Idle

While European stocks’ June outperformance may be temporary, there’s a decent chance that they can keep up the momentum. To F/m’s Carter, “Europe is value and the US is growth.” In the stock market, value and growth trade places, and he argued that cycle will continue.

For one thing, the US’s global competitiveness may be slipping, says a study by the Swiss-based International Institute for Management Development. Over the past two years, the US has dropped from among the top five to No. 10 among nations. After No. 1 Singapore, the next finishers were all from Europe: Denmark, Switzerland, and the Netherlands (Hong Kong was fifth). One of the main factors in the ranking is openness to trade, and the US’s trade war against China hurt it.

For another, the US tech colossus is in danger of losing its mojo. The stocks are very expensive, with Amazon changing hands at a price/earnings multiple of 130. What’s more, talk is stirring in Washington of antitrust action against the technology titans. Should the Democrats take the White House this fall, chances of that increase mightily. In addition, the decimation of oil prices—despite a comeback, they still are on the low side—remains bad news for a key US industry.

The artificial stimulus of share buybacks is waning in the US. After the 2017 tax cut awarded American corporations more cash, they shunted a lot of it into buybacks. That bonanza has faded. And as a recession takes hold, the corner office in the US is in no mood to funnel cash to shareholders when the dollars are needed as a buffer against the downturn.

Beyond all that is the extraordinary united front that the EU has forged to fight the downturn. With the sad exception of the UK, now facing a wrenching separation from the trading bloc at year-end, the continent has optimistic prospects.

In what portfolio manager Carter calls “a Hamiltonian moment,” the EU has agreed to a common €750 billion ($850 billion) recovery fund by selling bonds backed by all 27 members of the trading group. This is reminiscent of when Alexander Hamilton, the first US Treasury secretary, transferred all the states’ Revolutionary War debt to the federal government, clearing the way for economic growth. Meantime, the ECB is pumping $1.5 trillion into the EU.

Germany, the grumpy naysayer during the sovereign debt crisis, now is at the crux of this entente. Individual countries are giving tax cuts and cash grants to their people. Success at keeping the coronavirus at bay in northern Europe, particularly in Germany, have aided this effort. Some EU members, such as Germany and France, have subsidized companies so they didn’t have to lay off workers, which should help them rebound.

As Barclays put the matter, “The growth/quality nature of the US equity market remains a structural advantage versus Europe, but the end of the buybacks super-cycle and the collapse in oil prices could be more problematic for the former.”

And the word “former” may also apply to US stock hegemony.

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