Macro: Sandcastle economics
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Are European equities worth pursuing?
Peter Garnry
Chief Investment Strategist
Summary: Equity markets have diverged since the financial crisis with US markets outperforming their European counterparts by a wide margin. The question is, is this set to continue?
In our Q2 Quarterly Outlook published today, we argue that equity markets have diverged since the financial crisis in 2008. US equity markets have outperformed their European counterpartss by a large margin and profit growth has also been much stronger among US companies. The three main drivers of this divergence are higher US fiscal impulse, earlier QE in the US restoring balance sheets among US banks and lastly the US technology sector dominating monetisation in the Internet age.
US equities consequently trade at a large valuation premium of around 40% to European equities. The bigger question is whether this will continue into the future?
Strong trends in favour of the US
Long-term US earnings growth will likely be larger than Europe’s due to the three factors mentioned above. The US is likely to have higher fiscal deficits going forward as there is little will in Europe to increase government spending due to the euro area crisis in 2010-2012. As long as Europe does not do deeper fiscal and monetary integration, fiscal policies will likely be constrained compared to the US.
From a sectoral balance perspective, the larger US deficit will underpin profits in the private sector and serve as an engine for further gains in the US equity market. The monopolistic nature of many industries is most striking in the technology sector, where a few US companies completely dominate their niche segments, extracting excess profits.
While the EU has done some initial groundwork to weaken US technology companies. their power will only diminish very slowly, at best... think Microsoft.
US equities consequently trade at a large valuation premium of around 40% to European equities. The bigger question is whether this will continue into the future?
Strong trends in favour of the US
Long-term US earnings growth will likely be larger than Europe’s due to the three factors mentioned above. The US is likely to have higher fiscal deficits going forward as there is little will in Europe to increase government spending due to the euro area crisis in 2010-2012. As long as Europe does not do deeper fiscal and monetary integration, fiscal policies will likely be constrained compared to the US.
From a sectoral balance perspective, the larger US deficit will underpin profits in the private sector and serve as an engine for further gains in the US equity market. The monopolistic nature of many industries is most striking in the technology sector, where a few US companies completely dominate their niche segments, extracting excess profits.
While the EU has done some initial groundwork to weaken US technology companies. their power will only diminish very slowly, at best... think Microsoft.
In addition, US banks are healthy and thus credit enablers to a larger degree than their European counterparts. This stimulates profit growth for US banks which are still the second-largest segment of the US equity market. For long-term investors, US equities should most likely be overweighted against European equities.
Opportunities in European equities
Long-term dynamics is one game, short-term . In our equity outlook we expressed a negative view on European equities short-term based on Europe’s leading indicators being below trend and still falling as of January 2019. This environment (first column in table below) is typically negative on average for global equities, but in particular for European shares. In our outlook, we offer hope by highlighting that leading indicators for South Korea have already turned higher and evidence shows that South Korea has led global growth since 2008.
Yesterday’s March PMI figures on China and South Korea also confirmed that Chinese stimulus is beginning to work. We have increased the probability that OECD’s leading indicator published on April 8 will likely show that Asia has already turned and that sentiment will improve in Europe within three months.
Opportunities in European equities
Long-term dynamics is one game, short-term . In our equity outlook we expressed a negative view on European equities short-term based on Europe’s leading indicators being below trend and still falling as of January 2019. This environment (first column in table below) is typically negative on average for global equities, but in particular for European shares. In our outlook, we offer hope by highlighting that leading indicators for South Korea have already turned higher and evidence shows that South Korea has led global growth since 2008.
Yesterday’s March PMI figures on China and South Korea also confirmed that Chinese stimulus is beginning to work. We have increased the probability that OECD’s leading indicator published on April 8 will likely show that Asia has already turned and that sentiment will improve in Europe within three months.
When the cycle shifts to the next phase, below trend but expanding, investors should increase their exposure to Asia Pacific and North America. Europe has historically been weak in the recovery phase. Only very cyclical countries such as the Netherlands, Norway, Sweden and United Kingdom have shown attractive dynamics in this part of the economic cycle.
From a broader perspective, Europe does not deliver high returns until late into the short-term economic cycle. The big unknown against historical returns in the various economic cycles is Europe’s low valuation with German equities valued at a 35% discount to global equities. This could be so attractive that European equities might surprise to the upside when the economic cycle turns.
So our view on equities is still cautious/defensive with an overweight/positive view on early cyclical countries such as Australia, Hong Kong, South Korea and India.
From a broader perspective, Europe does not deliver high returns until late into the short-term economic cycle. The big unknown against historical returns in the various economic cycles is Europe’s low valuation with German equities valued at a 35% discount to global equities. This could be so attractive that European equities might surprise to the upside when the economic cycle turns.
So our view on equities is still cautious/defensive with an overweight/positive view on early cyclical countries such as Australia, Hong Kong, South Korea and India.
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