This year has seen UK investors flock back to European equities on the back of improving macroeconomic data and supportive monetary from the European Central Bank but not everyone is convinced that the region presents better opportunities than the US.
Over 2017 to date, investors based in the UK would have generated a much higher return from Europe than the US. FE Analytics shows that the Euro STOXX index has posted an 18.91 per cent total return over the year so far, in sterling terms, compared with an 11.38 per gain in the S&P 500.
This is in stark contrast to the recent past as the US index has made a higher return than the European index in seven of the past 10 full calendar years. Over the decade since the start of the financial crisis, the S&P 500 is up 219.68 per cent (in sterling) while the Euro STOXX has risen just 63.13 per cent.
Europe’s return to favour has been reflected in fund flows as well. The most recent figures from the Investment Association show that European funds captured net retail inflows of £220m in October 2017, compared with the £64m that flowed into North American funds.
Performance of indices over 2017
Source: FE Analytics
The reasons behind the move towards Europe are varied and include a strengthening economic outlook (the IMF has upgraded its growth outlook for both 2017 and 2018) and stimulative ECB policy (interest rates are at record lows and quantitative easing remains in place).
In the US, however, the Federal Reserve has ended its massive quantitative easing programme, unveiled plans to reduce its balance sheet and embarked on an interest rate hiking cycle. The market is pricing in a 98 per cent probability that the Fed will lift rates again in December and one or two increases are widely expected in 2018.
Added to this is the fact that valuations in Europe are seen as being much more attractive than those in US, given that the US has led the bulk of the post-financial crisis bull run while Europe has spent a large part of it being ignored.
With US markets trading at close to record highs and Europe experiencing a range of tail winds, it’s clear to see why many are tipping the latter as the place to be in 2018. However, there are a number of fund managers and strategists who believe sticking with the US might be a better idea.
Equity analysts at Jefferies recently looked at the “battle” between Europe and the US for investors’ funds and concluded that the argument in favour of Europe is not as compelling at it might seem at first.
“Since the market lows back in 2009, the US has smoked the European benchmarks and even in 2017, the US has won in both large- and small-caps,” the investment bank said in a recent note.
“Given the underperformance by Europe, investors believe a game of catch-up might be in store. In fact, European equities have seen inflows of over $100bn year to date, versus a measly $16bn for the US.
“However, when we looked at the relative valuations today versus where they stand historically, it was not clear to us that Europe is all that cheap. When we add in the fact that earnings estimates now need to rise for US companies due to tax cuts, the US clearly looks better to us.”
Valuations in US and European equities
Source: FactSet, Jefferies
The consensus view that Europe is cheaper than the US could be turned on its head by looming tax reform in the US. While conceding that equities in both regions look expensive, Jefferies’ analysts argue that US tax reform – which would include a deep cut to the corporate tax rate among other measures – would boost the earnings of US companies, thereby making them cheaper.
Nizam Hamid, ETF strategist at WisdomTree, agreed that if the tax reforms are pushed through, then US valuations would look at more attractive than they currently do.
“The benefits to shareholders can be quite mechanistic without accounting for any other benefits to the economy or any multiplier effect. Valuations, which have appeared stretched with historic P/Es [price-earnings ratios] of 22x for the S&P 500, look more reasonable if taxes are cut to 15 per cent, with the historic P/E then dropping to 19x,” he said.
“For many investors, however, the more important consideration comes with prospective P/Es based on current estimates of earnings growth. This reveals the full benefits of tax cuts and the positive impact on US equities valuations. To a certain extent this applies across the board from quality dividend growth stocks, high yielding equities and small-cap stocks. When one factors in both earnings expectations for the current year and the lowering of taxes, then P/Es fall dramatically into what could be considered relatively normal valuation ranges.”
David Coombs, manager of the Rathbone Multi-Asset Portfolio Funds range, has preferred the US over Europe for many years, a stance which until relatively recently was a fairly common view. However, he has not joined the many investors who have switched their “historically dreary opinion on European shares” to a more upbeat view.
Coombs highlighted a number of issues with the European economy, including the likelihood that inflation will remain muted, economic growth seems to have peaked at 2.5 per cent despite this being low for a region heavily tied to global commerce and persistently high unemployment across the bloc.
The multi-asset manager has a long list of things he would need to see change in order for him to become bullish on Europe: a reacceleration in global growth; a sustained increase in bund yields; better prospects for the financial and consumer discretionary sectors; and a global adjustment where value companies outperform growth.
Performance of indices over 10yrs
Source: FE Analytics
“We believe the great, fundamental shortcoming of Europe is the halfway house that is the EU. It needs true fiscal union for the project to work, to create significant blanket reform across the continent – rather than patchwork, beggar-thy-neighbour political moves – and spur higher economic growth,” Coombs concluded.
“There’s no appetite for such ever-greater union, which is why we continue to be dubious about the euro area. There are some great European companies – a few of which we own – but economic constraints mean we cannot bring ourselves to invest a substantial portion of our funds more widely in the EU. In short, we don’t see 2018 being any different: US stocks will outperform European ones, in our opinion.”