US and Europe – significant differences persist

Market Comment, November 2019

US and Europe – significant differences persist

Although European equities have made up some ground on their US counterparts this year, they lag well behind US equity markets in a long-term comparison. There are a number of key reasons why Eurozone stocks in particular have underperformed American equities over the longer term. And even if some of these factors change, we are still not expecting the kind of dramatic turnaround that would threaten the long-term superiority of US stock market performance. Below we highlight the important differences between the US and Europe – from both an economic and an equity market perspective. 

With 6% less, the performance of the European equity market last year was much weaker than its US counterpart. And although European equities have made up some of the lost ground this year, the US continues to lead the way in a long-term comparison. For example, since the recession-related nadir of 2002, the US S&P 500 index has risen by around 390%, the wider European Stoxx 600 index by about 250%, and the Eurozone’s Eurostoxx 50 by approximately 190%. When measured from the peak recorded at the start of 2000, the S&P has risen by around 210% (overall return as per November 2019), whereas the European Stoxx 600 has risen by only around half this amount, namely 105%, and the Eurozone’s Eurostoxx 50 by just 55%. By contrast, the Swiss SMI rose by 133%. What are the reasons for these significant differences in performance?

These relate first and foremost to fundamentals – in earnings development, varying levels of profitability in key sectors, and differences in economic development. On the profitability front, operating profit margins in the US are at 13%, compared to 12% in Switzerland and just 10% for the European Stoxx 600 or the Eurostoxx 50. 

This means that US companies are some 30% more profitable than their European counterparts. One reason for this difference is the higher weighting in the US of sectors with structurally higher profit margins: Technology and communications account for some 20% of the US stock market, almost three times the European equivalent figure of approximately 7%. By contrast, the weighting of the financial sector in Europe, in which profitability has been coming under pressure for many years, amounts to some 20%, which is the figure accounted for by sectors with high profit margins in the US. 

It is therefore only logical that corporate earnings in the US have risen much more strongly than in Europe. For example, the reported earnings of the S&P 500 have risen by 400% since the recessionary low of 2002, which is broadly in line with the gains made by this index and puts the higher valuation of the US stock market in better context. Europe meanwhile has recorded an increase in corporate earnings of just 230%, whereas Switzerland has seen 300%. 

“The profitability of the companies in the S&P 500 is 30% better relative to the firms in the European Stoxx 600.”

Gérard Piasko, Chief Investment Officer

In Europe too, the weighting of financial stocks as a proportion of the overall market rose to some 20% just before the financial crisis, and has been steadily declining ever since. And as (unlike in the US) no other innovative sectors such as technology/communication have exhibited dynamic growth and healthy profitability, the DJ Eurostoxx 50 equity index has never returned to its absolute peak (in 2000) and slightly lower peak (in 2007), much as Japan’s Nikkei 225 index has never been close to rescaling the peak recorded in 1990. This stands in stark contrast to the innovation-driven highs of the S&P 500 index in the US, which has set record after record in recent years – driven above all by the healthy profitability of its communication/technology sector, which has easily the highest weighting of any sector in the S&P 500. Ten years after the Nikkei peaked, Japan had to resort to quantitative easing after the failure of traditional measures to stimulate the economy in the form of numerous interest rate cuts. This involved the Bank of Japan initiating bond purchase programmes to bring down longer-term market interest rates, i.e. bond yields. As these extreme measures bore little fruit, the BoJ even launched equity purchase programmes. In summary, while Japan had no great success in stimulating its economy, it proved very profitable for investors who increased their bond and equity weightings at the expense of cash: The Bank of Japan’s asset purchase programmes made cash less appealing as an asset class, while adding an additional direct source of demand for other asset classes. Japanese institutional investors (e.g. pension funds) also increased their equity weightings and purchased more corporate bonds in order to avoid negative inflation-adjusted returns. The alternative monetary policy instrument of quantitative easing (“QE”) has also been part of the European Central Bank’s toolkit ever since 2015. Just a few weeks ago, the ECB announced that it would be launching a new round of QE in November, the aim being to purchase market securities up to a total volume of EUR 20 billion. Interestingly, no time limit has been set for the asset purchase programme this time around. In Japan, the benchmark yield on 10-year government bonds fell below 2% for the first time in 1997, while with the exception of 2014 inflation has never reached the desired 2% level – it currently stands at around 0%. In the Eurozone too, inflation has continually receded from the target level of 2% since the 2011/12 crisis, and currently stands at 1%. The benchmark yield on 10-year German government bonds fell below 2% for the first time in 2012, and is now below 0%. So what should we learn from Japan’s experiences when it comes to the ongoing asset purchase programmes of the ECB? On the one hand financial repression, which means it is only logical to take on debt to invest in securities or residential property. By contrast, those attemptings to save by holding liquidity (cash) can hardly hope to generate a positive return once inflation is taken into account. Institutional investors are having to take greater (diversified) risks to generate positive returns, e.g. by investing in real estate, corporate bonds, or equities. But at times they will have to take profits in order to benefit from the likely increase in volatility triggered by financial repression. Private investors too will recognize that positive returns simply cannot be generated in such an environment without the assumption of risk, because the price of financial repression is more volatile financial markets ‒ in all asset classes, and probably for many years to come.

Gérard Piasko

Gérard Piasko

Gérard Piasko is CIO and head of the investment committee of private bank Maerki Baumann & Co. AG. Before he was for many years CIO of Julius Baer, Sal. Oppenheim and Deutsche Bank.

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Editorial deadline: 8 November 2019

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