Europe – More “United” than the United States?
The STOXX Europe 600 advanced 21.04% year-to-date through August 25th. In local currency, this ranks best of the world’s regional returns and even squeezes ahead of the S&P 500’s 20.83% return over the same period. This is an impressive result, especially considering the much lower monetary stimulus applied in Western Europe compared to the US. Of course, the key question remains, can the continent maintain these competitive equity returns? As we spelled out in our May commentary titled “The EU – Driving Europe’s Revival” we believe the continent will continue to deliver competitive equity returns in the future.
Our contention is based, at least partially, upon structural changes in the European Union. As covered in our earlier discussion, the EU previously lacked effectiveness and was almost universally considered a bureaucratic nightmare. The Institution was relegated to trying to achieve consensus among squabbling-prone members with divergent economic and political objectives. Lack of consensus meant inevitable policy paralysis, lack of coordination, or worse, individual member policies at odds with each other, hurting the continent as a whole. However, the pandemic engendered several “forged-in-fire” EU organizational changes in 2020, which provide the EU greater political and economic power over the continent. Centralized power appears to be growing relative to any of the individual member countries. Notably, these include debt issuance capability and increased influence over how the money is spent. Complimenting the European Central Bank monetary policy, these new rights for stimulus, if used effectively, should create better economic growth and vitality compared to history. We believe this is happening.
Early in 2021, Europe appeared to be following a familiar pattern, badly lagging the US and China in economic recovery, this time caused by the pandemic. Critics noted a sluggish vaccination campaign, inconsistent lockdown policy, confusing travel guidelines, and inadequate stimulus. Initially, the euro-area followed the script with annualized GDP shrinking 1.3% in the first quarter 2021 compared to the 0.5% US expansion. Thus, most believed this portended continued US equity leadership similar to the decade-long US outperformance after the Global Financial Crisis. This was driven by the US’s sharper bounce in the economy and profits compared to Europe after the GFC. However, euro-area second quarter 2021 GDP handily beat expectations jumping 13.7% year over year, above the 12.2% US GDP annualized growth rate. Economists projected Europe would see unleashed pent-up demand in Q2 from easing Covid-19 containment measures, but apparently did not fully account for the fiscal support provided by the disbursement of EU recovery funds. Further, analysts misjudged Europe’s earnings strength. Company earnings have surprised analysts this earnings season, showing a 27.21% positive surprise rate, one of the world’s best.
The holy grail of investing is the combination of attractive growth prospects with cheap valuation. Stock returns benefit not only from earnings growth, but also the concomitant expansion in the multiple paid for that rising earnings stream. European equities appear attractive on both counts. The STOXX 600 Index constituents are projected to grow earnings 56.4% next fiscal year compared to 32.0% for the S&P 500. Yet, valuation decidedly favors Europe with the estimated price-to-earnings ratio 21% cheaper at 15.9 times for the STOXX compared to 20.3 times for the S&P 500, according to Bloomberg data. Other valuation metrics reflect a greater European advantage and may be more meaningful given analysts’ persistent inaccuracy in projecting earnings. Europe’s price to book, in other words the company’s price as a multiple to assets, stands at 2.2 times. This is less than half the S&P 500 price to book measuring 4.7 times. Granted, S&P 500 companies are more profitable than European companies with better return on capital and margins, but the S&P’s profitability advantage is modest compared to the price-to-book ratio spread.
On a price-to-free cash flow basis – a favorite metric of this author – the STOXX comes in at 9.7 times versus 31.3 times for the S&P. Admittedly, these metrics over simplify the valuation equation. As a going concern, a company’s value should be based on its long-term earnings power, not on any single year. There are also structural influences. The STOXX index is constructed with a larger allocation to cyclical stocks, and less intellectual property-intensive software companies, skewing the valuation metrics to Europe’s favor. That said, these ratios provide a good starting point for analysis, and valuation measures in combination with growth metrics have shown strong predictive value for relative results in the longer-term. Moreover, the disparity in some of these metrics appear to be at extreme levels.
Another factor in Europe’s favor appears to be a reversal in fund flows. Foreign investors consistently own more US stocks than US investors own foreign stocks, especially Europe’s. According to Goldman Sachs, direct ownership of US equities by foreigners account for 16% of the US corporate equity market. If including indirect ownership, i.e., mutual funds and other pooled investments, the proportion is higher, possibly as high as 40%. Given Europe’s long-term underperforming historical record, it’s easy to understand why global equity funds are structurally underweight Europe, but we note mutual fund flows into European equities year-to-date are the strongest in six years. Moreover, with the ECB unburdened with murmurs of tapering like the US Federal Reserve, and with Europe’s economy thought to be at an earlier stage of recovery, European equities should be positioned relatively well for the remainder 2021 and 2022.
Finally, as we highlighted in our May piece, “Will the Dollar Always be Mighty?”, the dollar appears overvalued against several currencies including the euro. Although tapering talk has supported the greenback near-term, the one-year, three-year, and five-year currency movements through July favor the euro and we expect the momentum to continue.
Note we are not suggesting Europe is immune to political instability, and despite the title, it is not more “united” than the US, at least for now. Relations with the most important EU member, Germany, remains contentious. But with the EU’s progress on several fronts including the successful handling of Brexit, better pandemic management, improved immigration coordination, and stimulus success, investor confidence towards Europe is improving. Understandably, US investors maintain higher allocations to their home market equities than the global index weightings, but therein lies an opportunity. By diversifying outside their home market, investors can lower their volatility by allocating away from a relatively narrow set of economic and market forces as well as expanding their opportunity set. We believe European equities, which are a key part of our International ADR and Global portfolios, will serve investors well who are seeking this opportunity.
The foregoing content reflects the opinions of Advisors Capital Management, LLC and is subject to change at any time without notice. Content provided herein is for informational purposes only and should not be used or construed as investment advice or a recommendation regarding the purchase or sale of any security. There is no guarantee that the statements, opinions or forecasts provided herein will prove to be correct. Past performance may not be indicative of future results. Indices are not available for direct investment. Any investor who attempts to mimic the performance of an index would incur fees and expenses which would reduce returns. Securities investing involves risk, including the potential for loss of principal. There is no assurance that any investment plan or strategy will be successful.
