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Written by: Richard McGrath | AGF
Improving fundamentals and attractive valuations may lead to better performance relative to U.S. counterparts.
European equities have played second fiddle to the U.S. for years now. While the S&P 500 Index’s new highs just seem to provide support for the next step up, Europe’s all-time highs seem to act as glass ceilings or anchors. Even this year, with the S&P 500 up more than 20% to the end of October, the comparable STOXX Europe 600 Index is struggling to get to double-digit returns.
Several factors have driven the STOXX Europe 600’s historical underperformance, namely, sluggish economic and earnings growth, as well as political volatility. Weak demand and macro uncertainty have created a severe lack of confidence. All those factors are well understood and seem to be reflected in equity valuations. The S&P 500 forward price-to-earnings ratio now stands at 22, compared with 13 in the STOXX Europe 600 Index . That represents a 40% discount – a multi-decade low for European stocks’ comparative valuation, even after adjusting for sector differences between the two equity markets.
Value Gap
Source: Bloomberg LP as of October 31, 2024. One cannot invest directly in an index.
The headwinds look set to ease into 2025, however, providing a more positive backdrop for the region. Lower oil prices will keep energy prices and inflation down. The European Central Bank has cut interest rates three times already from the highs, which could support economic growth. Unemployment remains low and China is starting to accelerate, which is important for European exports. We expect these tailwinds should provide a boost to economic growth and help to narrow the gap between Europe and the U.S., especially if, as expected, the American economy begins to slow.
It's a similar picture with corporate earnings. There is no denying that earnings performance in Europe for 2024 will be poor, with average expectations around the low- to mid-single digit levels. Next year, however, European earnings are expected to see growth rates approach the 10% levels, helped by the lower base, while the U.S. is expected to see earnings growth slow to around 15%. So, Europe may continue to lag, but by less than in 2024.
One negative for Europe going into 2025 is the deficit reduction programs being forced on several countries, for example Italy and France. Under the European Union’s Growth and Stability Pact, any country running an excessive deficit needs to show the parliament how it plans to pare it to 3% of gross domestic product (GDP). Meanwhile, the new Labour government in the United Kingdom introduced a “tough love” budget of its own. Lower government spending and higher taxes could adversely effect both economic growth and corporate profitability – a headwind for European equity valuations relative to the U.S., where president-elect Donald Trump is likely to expand an already sizable budget deficit. At least for now, the equity market is reacting negatively to Europe’s fiscal conservatism, despite the balance sheet strength this might create over the long term, and focusing on the potential short-term growth benefits on offer in the U.S.
Lower oil prices will keep energy prices and inflation down.
Meanwhile, the political gains of far right and far left parties across the continent – especially in Germany, Austria and the European parliamentary election in France – have made headlines this year. Each country’s extremist parties promote slightly different agendas, but they can be summed up as being anti-immigration and focused on cultural protectionism. For the moment, the incumbent centrist parties retain power, and the new European Parliament and Commission, which will be in place by the end of the year, seems prepared to bend to the wishes of the people and begin to look for ways to ease populist concerns. It will also focus on adopting Mario Draghi’s report on European competitiveness through focusing on economic growth and productivity, but also by also “preserving our values of equity and social inclusion.”
The lack of confidence in Europe has not only translated into stock price underperformance, but also low levels of ownership. Equity investors are net short Europe and are at near maximum overweight positions in the U.S. The U.S. presidential election seemed to exacerbate this trend, as the Trump victory and his promised trade tariffs gave investors yet another reason to lighten up their weighting in Europe.
That said, much of the potential bad news for European stocks has clearly been priced into the equity market already. European stocks have under-performed, they are cheap, their fundamentals are improving, and Europe’s governments are trying to fix imbalances in the system.
No doubt, Europe has a substantial amount of work to do, and it will not fix all its problems in 2025. But the old adage that “things are always darkest before the dawn” seems to be a fitting one here.
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