Making Sense of Calls for Eurozone Outperformance

Eurozone stocks have lagged US since this bull market began on March 23—48.3% versus 54.6%—continuing the last bull market’s geographic leadership trends.^[i] But that hasn’t stopped many commentators from arguing the eurozone is poised to lead the US in this new market cycle. Yet in our view, most of the reasons they offer are backward-looking and, crucially, ignore the region’s market structure. While we think global investors should own eurozone stocks for diversification purposes, we wouldn’t expect the region to outperform absent an unlikely rotation to value leadership.                                

Principally, the reasons headlines cite for likely eurozone leadership are as follows: The euro has strengthened against the dollar, which adds to US investors’ returns on eurozone stocks; Congress is deadlocked over new COVID relief measures, while the EU recently approved an expansive budget; and US price-to-earnings ratios are higher than the eurozone. We don’t think any are good reasons to favor eurozone stocks presently.

Let us start with the currency swings. It is mathematically true that a weaker dollar adds to US investors’ overseas returns. In euros, eurozone stocks have risen 35.7% since March 23.^[ii] But the euro’s appreciation versus the dollar adds to that, boosting US investors’ returns on eurozone stocks to 48.3% when denominated in dollars.^[iii] This is because Americans investing with dollars get the companies’ appreciation plus the extra juice from currency translation. But that isn’t the sole driver of relative returns, and currency cycles don’t align with geographic stock market leadership. The euro was born on January 1, 1999. It weakened significantly against the dollar for over a year and a half, reaching its all-time low versus the dollar on October 25, 2000.^[iv] US stocks did outperform the eurozone during that stretch. 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.

After the financial crisis, the euro spent most of the new bull market’s first five years stronger than its present level, but US stocks still outperformed by a country mile during that stretch. 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 from February to September 2011. We aren’t saying anyone did that, but the extreme scenario is illustrative nevertheless. Currency swings may be additive at times, but they aren’t predictive, and fundamental factors have much more impact on relative returns, in our view.

Those fundamental factors don’t include valuations. If stocks with lower valuations were always primed for outperformance, then value stocks would always outperform growth. But the two swap leadership often. Since the beginning of this century, there is 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 8/20/2020. S&P 500 and MSCI EMU Index forward P/E ratios at calendar year-end and returns in the next calendar year, 12/31/1999 – 12/31/2019. S&P 500 total returns and MSCI EMU Index returns with net dividends.

Even during the last, overall US-dominated bull market, financial commentators often called for eurozone stocks to lead based on their lower P/E ratio. For example, a March 18, 2014 Financial Post article touted the fact “equity valuations in most European nations also remain inexpensive relative to other global jurisdictions.”^[v] Over the next 12 months, the S&P 500 returned a fine 13.1%—while eurozone stocks fell -6.3% in dollar terms.^[vi] About a year later, a CNN Money piece published on Valentine’s Day 2015 argued investors should fall in love with eurozone stocks due to their cheap valuations relative to America’s.^[vii] Yet over the next 12 months, US stocks outperformed amid a global correction—and the recovery that ensued thereafter. Even as last year was winding down, investors polled by Reuters argued surging US valuations pointed to eurozone leadership this year. While 2020 has been highly unusual, suffice it to say those lower valuations haven’t helped.^[viii]

Arguments the eurozone should lead based on the Continent’s large fiscal response to COVID are similarly unpersuasive, in our view. Fiscal measures designed to cushion lockdowns’ impact largely aim to tide over small businesses and consumers. They aren’t stimulus. But even if they were, they are too widely known to have any forward-looking effect. Markets move most on surprises, and nothing about the eurozone or US’s fiscal response to COVID is a surprise. Investors already know the eurozone’s spending will occur in fits and starts over the next few years. It is already reflected in current prices. To argue it will drive relative returns is to presume 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 expect large growth-oriented companies, including the biggest Tech and Tech-like stocks, to lead for the foreseeable future. The eurozone has relatively low Tech exposure and tilts heavily toward value stocks—this is why eurozone valuations have lagged America’s for most of the last 20 years.

Value companies tend to carry more debt and be more dependent on economic growth—a quality that makes them more vulnerable in recessions. Consequently, their stocks typically plunge much more than growth companies in a bear market’s later stages as panicked investors fear many won’t survive the recession—and then bounce most when panic subsides and new bull market begins, relieving those heightened fears. February – March’s bear market didn’t last long enough for investors to work through this full sentiment cycle. It ended before the recession began showing up in economic data. 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. In many ways, the bear market acted more like a huge correction, despite its magnitude and fundamental cause. That also argues against a leadership shift. We think this is a big reason why growth stocks led at the end of the last bull market, during the bear market and in the recovery to date. Value stocks have had brief bursts of leadership, but countertrends are normal.

Don’t get us wrong: This is a global bull market, and accordingly, we expect eurozone stocks to do well. US and eurozone stocks are highly correlated—one rarely zigs while the other zags for long. But that is a statement about direction, not magnitude. We think global investors still benefit from eurozone exposure for diversification, but we think the wisest move is to own eurozone stocks as a counterweight, not an overweight.