Can Europe’s Dismal Decade Turn Around?
European stock markets are currently having their worst 10-year stretch for relative returns compared with the U.S. stock market in 40 to 50 years.1 Despite continued Brexit uncertainty weighing on sentiment, investors might want to start paying attention to European equities again.
Ever since the financial crisis, the U.S.’s role in global capital markets has become increasingly dominant, with European equities compounding returns over 600 basis points (bps) per year less than the S&P 500 Index’s returns over the most recent decade.
Anecdotally, we often hear that Europe’s inability to keep pace with the U.S. over the past decade is caused by over-weight positions in banks, which have struggled in the post-crisis environment, and the absence of firms comparable to the U.S. tech giants.
I examined this narrative by running an attribution report of the performance differential for the MSCI USA Index compared with the MSCI Europe Index over the last decade.
The attribution analysis was done in local currency terms for European markets because if it had been measured in U.S. dollars, Europe’s underperformance would have been even worse!
- The top contributing sector to Europe’s underperformance was Information Technology. Europe had less than 4% weight on average in the Information Technology sector over the last decade, compared with almost 20% in the MSCI USA Index. The U.S. Information Technology sector returned 17% per year this last decade, 11 percentage points ahead of the European markets as a whole. This explains over a quarter of the total gap in average annual returns and illustrates the differences in composition between each region’s equity market.
- The Financials sector was the next biggest contributor. While Europe had more weight in financials, European financials lagged U.S. financials by almost 1,000 bps per year for a decade. This toxic combination accounted for another quarter of the annual returns gap.
- Not all of the big U.S. tech firms are classified in the Information Technology sector, however. Amazon is classified as a Consumer Discretionary company, while Facebook and Google2 are in the Communication sector. When you look at these two additional sectors, they explain another quarter of the relative return gap between the U.S. and Europe.
- In short, the Information Technology and Financials sectors made up approximately 75% of the outperformance of the U.S. market, while the other 25% is attributed to the secular outperformance of U.S. stocks versus European stocks in basically every sector outside Energy.
Many value-minded investors may see this raw gap in relative returns and get attracted to the potential for mean reversion.
In the 30 years prior to 1999, European markets had outperformed U.S. markets, even when measured at the peak of the U.S. tech bubble.3 So, who is to say the U.S. will always outperform looking forward?
The higher returns in the U.S. were fully supported by underlying fundamental earnings trends: European earnings contracted 23% cumulatively over the last decade while U.S. earnings grew over 40%. The average annual growth rate differentials in these earnings metrics is close to 6%, which is essentially the same difference in relative outperformance between each equity market.
Whether European markets are destined to mean revert and outperform the U.S. boils down to expectations for relative earnings growth.
- European banks have been under enormous pressure. Structural forces are weighing on net interest margins, a key measure of bank profitability and lending activity, and there is a lot of excess capacity in European banks, but low valuations make consolidation very hard.
- Germany is being dragged down by a manufacturing slowdown that corresponds to weakness in global auto sales, global capital goods expenditures and especially weakness in China.
- There also remains uncertainty around Brexit and how the United Kingdom will leave the European Union that casts another shadow over European markets.
All this uncertainty makes allocations to European equity markets quite hard, but also potentially quite rewarding when the earnings outlook and sentiment inflects more positively.
The most immediate catalyst could be a resolution of global trade tensions, which has hurt China, emerging markets and ultimately Europe as well.
Further, a change in fiscal spending from countries with surpluses such as Germany could be a positive surprise that many may consider only a remote possibility today.
One European investment strategy to consider would be the WisdomTree Europe Hedged Equity Index Fund (EHE), as we believe there’s reason for taking less risk when investing abroad by using a currency-neutral approach. By hedging, investors can mitigate their exposure to fluctuations in the euro, which adds another layer of risk management within the portfolio. That way, investors can purely expose themselves to dividend-paying companies in the European equity market to take full advantage of potential upside. The Fund’s underlying index also applies a screen to ensure that all eligible companies derive at least 50% of their revenue from countries outside of Europe, which provides an extra layer of global integration and diversification.
In our view, Europe’s lackluster performance over the past decade may not last indefinitely. Despite the region being out of favour for investors lately, we consider Europe to be important to a global asset allocation plan. But just because investor sentiment may be negative, that doesn’t mean that there’s no opportunity in the market; you just need to know where to look for it.
Unless otherwise stated, all data is from Bloomberg, WisdomTree and FactSet as of October 8, 2019.
1Sources: MSCI and WisdomTree research, as of 10/8/19.
2Please note that Amazon, Facebook and Google are not held in any of the exchange-traded funds mentioned in this post and are not eligible for inclusion, either.
3Based on WisdomTree and MSCI Index research, as of 10/8/19.