Making Sense of Calls for Eurozone Equity Market Leadership

Eurozone markets have lagged US since this bull market began on 23 March—30.4% versus 35.6%—continuing the geographic leadership trends of the last bull market (prolonged period of generally rising equity prices).^[i] But that hasn’t stopped many financial commentators we follow from arguing the eurozone is poised to lead the US in this new bull market. Yet in our view, most of the reasons they offer are backward-looking and, crucially, ignore the region’s market structure—the proportion of its equity markets comprised by various equity sectors and styles. Whilst we think global investors benefit from owning eurozone shares for diversification purposes, we don’t think the region’s equity markets are likely to outperform US equity markets over the period ahead.                               

Principally, the reasons we see headlines citing for likely eurozone leadership are as follows: The euro has strengthened against the US dollar, which adds to US investors’ returns on eurozone shares (a mathematical concept we will explain momentarily); the US Congress is seemingly deadlocked over new COVID relief measures, whilst the EU recently approved an expansive budget; and the S&P 500’s forward price-to-earnings ratio—which compares current share prices to analysts’ expectations for company earnings over the next 12 months—is higher than eurozone.^[ii] We don’t think any are good reasons to favour eurozone markets presently.

Let us start with the currency swings. It is mathematically true that a weaker dollar adds to US investors’ overseas returns, just as a weaker pound adds to British investors’ returns on non-UK investments. In euros, eurozone shares have risen 35.6% since 23 March.^[iii] But the euro’s appreciation versus the dollar adds to that, boosting American investors’ returns on eurozone shares to 48.4% when denominated in dollars.^[iv] This is because Americans investing with dollars get the companies’ appreciation plus the additional gains from currency translation. But we don’t think that is the sole driver of relative returns, and currency cycles don’t appear to align with geographic equity market leadership. The euro was born on 1 January 1999. It weakened significantly against the dollar for over a year and a half, reaching its all-time low versus the dollar on 25 October 2000.^[v] US equities did outperform the eurozone in dollars during that stretch.^[vi] But they kept outperforming, overall and on average, through mid-March 2003—by which time the euro had climbed back near its beginning exchange rate.^[vii]

After the 2008 financial crisis, the euro spent most of the new bull market’s first five years stronger than its present level, but US equities still outperformed by a country mile during that stretch.^[viii] Investors focused on the euro’s value alone would have missed a major fundamental negative: the eurozone’s debt crisis, which caused a regional bear market (fundamentally driven equity market decline of -20% or worse) from May 2011 to June 2012.^[ix] We aren’t saying anyone did that, but we think the extreme scenario is illustrative nevertheless. Currency swings may be additive at times, but they aren’t predictive, in our view, and fundamental factors have much more impact on relative returns.

But we don’t think those fundamental factors include valuations. Since the beginning of this century, we see no consistent relationship between US and eurozone P/Es and market leadership. As Exhibit 1 shows, eurozone forward P/Es trailed S&P 500 forward P/Es at the beginning of 18 of 20 completed calendar years from 2000 onward—yet leadership over the next year was a literal coin flip.

Exhibit 1: Forward P/Es and Forward 12-Month Returns (Calendar Year Basis)

Source: FactSet, as of 20/8/2020. S&P 500 and MSCI EMU Index forward P/E ratios at calendar year-end and returns in the next calendar year, 31/12/1999 – 31/12/2019. S&P 500 total returns and MSCI EMU Index returns with net dividends in US dollars. Currency fluctuations between the dollar and pound may result in higher or lower investment returns, although the above chart would look the same when using returns denominated in sterling.

Even during the last, overall US-dominated bull market, we often saw financial commentators call for eurozone equities to lead based on their lower P/E ratio. For example, an 18 March 2014 Financial Post article touted the fact “equity valuations in most European nations also remain inexpensive relative to other global jurisdictions.”^[x] Over the next 12 months, the S&P 500 returned a fine 13.1%—whilst eurozone equities fell -6.3% in dollar terms.^[xi] (For UK investors, returns in GBP were 26.3% for the S&P 500 and 5.3% for eurozone shares.) About a year later, a CNN Money piece published on Valentine’s Day 2015 argued investors should fall in love with eurozone shares due to their cheap valuations relative to America’s.^[xii] Yet over the next 12 months, US equities outperformed amid a global correction (a short, sharp, sentiment-driven decline of -10% to -20%)—and the recovery that ensued thereafter.^[xiii] Even as last year was winding down, investors polled by Reuters argued surging US valuations pointed to eurozone leadership this year.^[xiv] Whilst 2020 has been highly unusual, we think it suffices to say those lower valuations haven’t helped.^[xv]

Arguments eurozone markets should lead US markets based on the Continent’s large fiscal response to COVID are similarly unpersuasive, as based on our analysis, fiscal measures designed to cushion lockdowns’ impact largely aim to tide over small businesses and consumers. They aren’t stimulus (meaning, a massive boost to demand), in our view—and even if they were, we think they are too widely known to have any forward-looking effect. Markets move most on surprises, and we don’t think anything about the eurozone or US’s fiscal response to COVID is a surprise. In our view, investors already know the eurozone’s spending will occur in fits and starts over the next few years, which means it is probably already reflected in current prices. We think that arguing it will drive relative returns between US and eurozone markets presumes markets are largely inefficient.

In our view, the primary determinant of relative US and eurozone returns at this juncture isn’t country-specific economic or political drivers, but simple market structure. We think large growth-orientated companies—those that tend to reinvest relatively more of their profits into growth-orientated endeavours and have relatively higher valuation metrics such as price-to-earnings ratios—including the biggest Tech and Tech-like shares, will likely lead for the foreseeable future. The eurozone has relatively low Tech exposure and tilts heavily toward value shares (those that are widely seen as undervalued and usually return more of their profits to shareholders via dividends rather than reinvesting them into growing the company) features we think help explain why eurozone valuations have lagged America’s for most of the last 20 years, as Exhibit 1 demonstrated.

Our research indicates value companies tend to carry more debt and be more dependent on economic growth—qualities that can make them appear more vulnerable in recessions. Consequently, their shares often plunge much more than growth companies’ in a bear market’s later stages as panicked investors seemingly fear many of these value-orientated firms won’t survive the recession—and then bounce most when panic subsides and new bull market begins, relieving those heightened fears.^[xvi]

We don’t think February – March’s bear market lasted long enough for investors to work through this full sentiment cycle—instead ending before the recession began showing up in economic data. In our view, that robbed investors of the chance to give value its typical late-bear market pounding, so the stage was never set for an early-bull market surge. This is one of the many ways we think the bear market acted similarly to a huge correction, despite its magnitude and fundamental cause. In our view, that also argues against a geographic or sector-based leadership shift. We think this is a big reason why growth-orientated shares led at the end of the last bull market, during the bear market and in the recovery to date.^[xvii] Value-orientated shares have had brief bursts of leadership, but we think countertrends are normal.^[xviii]       

We do think this is a global bull market, and accordingly, we think eurozone equities are likely to do well. Our research indicates US and eurozone markets are highly correlated—one rarely zigs whilst the other zags for long. But that is a statement about direction, not magnitude. We think global investors still benefit from some eurozone exposure, but we think the wisest move is to own eurozone equities primarily for diversification purposes, not as the largest component of their portfolios.