In times like these, it’s easy to become absorbed by politics but often much bigger market forces are the primary driver of relative equity market performance.
The S&P 500 has continued to strongly outperform the UK’s FTSE All-Share or the MSCI Europe ex-UK index over the course of 2024. As a result, the UK equity market now trades at a discount of nearly 50% to the US benchmark, and the MSCI Europe ex-UK index at a discount of over 35%.
Is such a discount on European stocks justified? Should investors contemplate rebalancing towards the stocks that Europe has on sale?
One might be tempted to disregard this notion in the face of a new US president with a very clear ‘America first’ mandate, and given that Europe’s recovery was lacklustre even before the prospect of renewed trade tensions. However, we see several reasons why investors should consider regional diversity in their equity allocations.
Europe has a much lower hurdle to beat expectations
There is a large gulf between expectations for US companies and those for their European peers (Exhibits 15 and 16). S&P 500 earnings are expected to grow by 14% over the next 12 months, and the index trades on a multiple of 22x those earnings. In contrast, earnings for the MSCI Europe ex-UK are forecast to grow 8% over the next 12 months, and the index trades on 14x those earnings. Earnings for the companies in the FTSE All-Share are expected to grow at 8% and the multiple on those earnings is just 11x. Thus, a significant degree of European underperformance is already priced in.
Part of Europe’s valuation discount at the benchmark level is due to sector composition. The region has far fewer tech stocks than the US market, and so has not benefitted from AI-related investor optimism. Instead, European indices contain more industrials, financials and commodity companies, which have faced challenges stemming from muted global goods demand, fear of non-performing loans, and a weaker Chinese economy.
However, every European sector currently trades at a discount well above the normal versus its US counterpart (Exhibits 17 and 18). This reflects general investor pessimism about European revenue and margin prospects.
Policy stimulus is likely to be greater than the market currently expects
We suspect it will become clear that while the new US administration will quickly levy tariffs on China, relations will be less hostile with Europe. This alone could support sentiment towards European assets. However, Europe’s trade-heavy economies will nonetheless be affected by restrictions on global trade, particularly if the European Union (EU) is forced to follow the US and impose restrictions on Chinese imports to protect its industries from excess Chinese supply.
A mitigating factor that investors may be underestimating is the response of European policymakers. We are confident that the European Central Bank will continue on an easing path, since Trump’s policies could reignite inflation in the US but dampen inflationary pressures within continental Europe as the European growth outlook faces tariff-related risks. Lower interest rates could incentivise consumers to spend some of the savings accumulated during the pandemic.
Some European leaders also have fiscal levers that they could pull to counter the effects of more aggressive trade policy and, as the decline in voting intentions for the fiscally conservative FDP party in Germany suggests, this is something the electorate appears to be hoping for. At the very least, efforts to reduce deficits are likely to be very gradual, with domestic industrial, energy and military security taking precedence. In addition, we might finally see European countries make more urgent efforts to deploy the more than 50% of the EU Recovery Fund that remains to be disbursed.
In the UK, the economy’s underlying structural dynamics suggest inflation may persist for a little longer than in its European neighbours. That said, there is still room for the Bank of England to cautiously ease its foot off the brake further. And while the recent budget was already expansionary, we suspect the new government will come under further pressure to meet its prior commitments on defence, as well as bolstering its as yet unspecified plans to boost investment.
It's also possible that these policy surprises in Europe come at a time of policy disappointment in the US, if it becomes clear that Trump does not have the backing of the more traditionally conservative Republicans in the Senate for additional corporation tax cuts.
How tech stocks perform is more important than Trump
In times like these, it’s easy to become absorbed by politics but often much bigger market forces are the primary driver of relative equity market performance. We would argue that the outlook for US technology stocks over the coming four years may well end up playing a greater role in the relative performance of US versus European benchmarks than Trump’s policies, since 32% of the US benchmark is tech, versus 9% in MSCI Europe ex-UK and just 1% in the FTSE All-Share.
Our core belief is that US tech is not a bubble and these companies will grow into their valuations as earnings expand through widespread technology adoption (Exhibit 19). However, if these companies disappoint on earnings, this will act as a major drag on the relative performance of the US, as we saw after the 2000 bubble burst (Exhibit 20).
The UK’s cash yield is getting ever more enticing
It is well-known that UK companies pay a healthy dividend: 4% on the FTSE All-Share, relative to the 1% available from the S&P 500. As we outlined in our recent On the Minds of Investors, however, buybacks have also picked up, suggesting that the chief financial officers of UK-listed companies view their shares as too cheap. UK buyback yields now exceed those on offer in the US market, with the FTSE All-Share offering a current cash yield of close to 6%. What’s more, merger and acquisition activity is picking up, which should be another supportive factor for valuations.
Overall, while the re-election of President Trump does appear to reinforce a narrative of American outperformance, investors might wish to consider the above factors when determining the magnitude of any US overweight. Within the basket of European stocks, we have a preference for UK equities. As the old investment adage goes, ‘it’s not just what you buy, it’s also what you pay for it’.