“Europe was created by history. America was created by philosophy.” – Margaret Thatcher “In America everything goes and nothing matters, while in Europe nothing goes and everything matters.” – Philip Roth, American novelist and modern literary great

MSCI Europe Index vs. S&P 500 Index – Total Return in USD Source: Bloomberg

In the ten years since the global financial crisis, European stocks have underperformed US stocks by a considerable margin.

In the first three years following the global financial crisis, the performance of the two markets were not too dissimilar. For the period commencing end of November 2008 through October 2011, the MSCI Europe and S&P 500 indices generated total returns of 46 and 53 per cent in US dollar terms, respectively.

Since late 2011, however, investors in European stocks have been left frustrated all the while investors in US stocks have enjoyed a long-running bull market. From 29 October 2011 through 20 November 2018, the MSCI Europe Index has generated a total return of 35.8 per cent in US dollar terms – 102.8 per cent less than the total return of the S&P 500 Index for the same period.

Despite, the strong outperformance of US equity markets relative to European equity markets, European stocks have been more expensive, on a trailing 12 month price-to-earnings basis, for the majority of the time since late 2011. Only since late 2017 have European equities become cheaper than US equities on a trailing 12 month price-to-earnings basis.

MSCI Europe vs. S&P500: Trailing 12 Month Price-to-Earnings Ratio Source: Bloomberg

At an index level and since the global financial crisis, US companies have grown revenues and earnings at a faster clip than their European companies.

MSCI Europe vs. S&P500: Revenue Growth Source: Bloomberg

MSCI Europe vs. S&P500: Earnings Growth Source: Bloomberg

In terms of annual performance, European markets have outperformed US markets in three out of the nine calendar years since the global financial crisis: 2009, 2012, and 2017. Notably, in 2009 and 2017, European companies’ year-over-year earnings growth rates were far superior to those of American companies. While outperformance in 2012, can be attributed to Signor Draghi uttering those famous words that brought Europe back from the brink: “Whatever it takes”.

European earnings also outpaced US earnings during the years 2010 and 2013, yet US stocks outperformed European stocks. The year 2010 was, of course, when the sovereign debt crisis engulfed the peripheral members – Portugal, Italy, Ireland, Greece and Spain – of the European Monetary Union. While in 2013, although European equities underperformed US equities , it was still a very good year for Europe with the MSCI Europe Index generating a total return of around 23 per cent in US dollar terms versus around 28 per cent for the S&P 500 Index.

Digging a little deeper we compare the performance between US and European markets on a sector-by-sector basis, using the Global Investment Classification Standards (GICS) level 1 classifications.

US vs. Europe: 5- and 10-Year Sector Level Total Returns (USD)

Source: Bloomberg

Note: Periods ending 31 Oct 2018, calculated using monthly data, and excludes real estate

For both the 5- and 10-year periods for every sector except energy, US performance has been superior to European performance – we have excluded real estate as we were unable to gather clean data for the sector.

The US energy sector has lagged the European energy sector largely due to the much higher number of listed shale oil companies in the US. Shale oil plays witnessed significantly larger drawdowns as compared to blue chip oil producers following the sharp drop in oil prices in late 2014.

For the 10-year period ended 31 October 2018, the greatest difference in performance between the two markets comes from the consumer discretionary and information technology sectors. The consumer discretionary sector includes Amazon and used to include Netflix – a significant portion of US consumer discretionary outperformance can be attributed to Amazon and Netflix. While the outperformance of the American information technology sector has been broader than that of the consumer discretionary sector, a handful of stocks still have had an outsized impact on US outperformance. These stocks are namely Apple, Google, Facebook, Salesforce.com, Microsoft and Nvidia. (Note: In January 2018 the industry classification of Google, Facebook, and Netflix was changed to communication services).

The most comparable performance between the two markets, for the 10-year period, comes from the energy, materials, consumer staples and industrial sectors.

US vs. Europe: 5-Year Sector Level Revenue and Earnings Growth

Source: Bloomberg

The above table details the 5 year (4-years for communication services) revenue and earnings growth by sector for US and European stocks.

Notably, in the US, net margins expanded from 2012 through 2017 across all sectors except energy. While in Europe, margins expanded for six sectors and declined for three – margins declined for the consumer discretionary, utilities and communication services sectors.

Median sector level revenue growth in the US for the five-year period was 20.96 per cent versus -2.26 per cent in Europe. (Earnings level comparisons are not meaningful in our opinion due to the artificially high earnings growth in certain sectors in Europe due to write-downs / exceptional circumstances in 2012 that understate earnings at the beginning of the period.)

Investment Perspective

The underperformance of European equities relative to US equities over the last five- and ten-years can predominantly be explained by fundamental factors. The challenge at this juncture, however, becomes that of identifying scenarios under which European stocks would arrest this trend of underperformance and begin outperforming the US stocks on a prolonged basis. We outline three such scenarios below.

If the next ten years are not like the last ten years

If we assume, simplistically and without trying to predict how, that the next ten years will be unlike the last ten years then there should be a preference for non-US stocks over US stocks in general.

In capital markets dominated by passive allocations to market capitalisation weighted indices, the main drawback is that the allocation to ‘go-go’ stocks is at its highest when they are at their peak relative to other stocks in the indices.

With respect to the S&P 500 Index, the information technology, healthcare, financials, communication services and consumer discretionary sectors have gone from representing 58 per cent of the index at the start of 2009 to almost 70 per cent today. And within these sectors the increase in allocation to technology and technology related stocks has been even more pronounced.

S&P 500 Index Allocation by GICS Level 1 Source: Bloomberg

The change in sector allocation for US indices has been far more prominent than it has been for European indices – simply because the dispersion in performance between sectors has been much greater in the US. Over the last ten-years the top performing sector in the S&P 500 Index has outperformed the median sector by almost 260 per cent. In comparison, the total return differential between the best performing and median sectors is 63 per cent for the MSCI Europe Index.

MSCI Europe Index Allocation by GICS Level 1 Source: Bloomberg

Labour not capital is rewarded

“The defining characteristic of economics in the 1950s is that the country got rich by making the poor less poor. Average wages doubled from 1940 to 1948, then doubled again by 1963. And those gains focused on those who had been left behind for decades before. The gap between rich and poor narrowed by an extraordinary amount.”

– Excerpt from Morgan Housel’s piece How This All Happened:

In the aftermath of the global financial crisis, unemployment levels shot up across the world. The global economy has spent the last ten-years healing from the damage wrought by the financial crisis. Slack in the labour market has been slow to dissipate and wages have remained stubbornly stagnant.

The corollary of the abundance of labour has been capital owners benefiting at the expense of labour.

As the global economy has healed, unemployment levels have gradually declined and wage pressures have slowly emerged. The European labour market, however, has much more slack than the US labour market – where unemployment levels are reaching twenty year lows and wage pressures are much more significant.

If demand for labour picks up globally, Europe has much more room to reduce unemployment levels before wages have to pick up meaningfully. Whereas the US has limited, if any, room for unemployment levels to drop lower without a meaningful increase in wage inflation. Therefore, Europe has greater flexibility to facilitate an improvement in household earnings without it impacting profit margins.

Capital investment / infrastructure spending pick ups

US corporations have been far savvier capital allocators than their transatlantic counterparts – they have reduced equity, through share buy backs, and increased leverage during a time when servicing debt has never been easier. The behaviour of US corporations has been facilitated not only by record low interest rates but also by a limited need for capital investment – a deflationary environment incentivises the postponement of capital investment.

If capital investment picks up globally – motivated by inflation, infrastructure development led diplomacy, such as China’s Belt and Road Initiative, or a need to reconfigure global supply chains due to trade wars – European indices, with their much greater weighting to the industrial and materials sectors, are better placed to outperform the more technology leaning US indices in such a scenario.

Moreover, increasing capital investment may spur demand for credit in Europe and support the much maligned European financial services sector, which also happens to be the sector with the highest allocation in the MSCI Europe Index.

This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.