Evaluating the European Equity Market
Additional content provided by Brian Booe, Associate Analyst, and Colby Hesson, Analyst.
Political uncertainty is ratcheting higher in Europe after French President Emmanuel Macron called for a snap election amid the rise of the National Rally Party’s Marine Le Pen. The news initially sent French stocks and bonds lower due to the potential budget implications before markets bounced back last week. Though this political turmoil is not an existential threat to the Eurozone like the European debt crisis in the early 2010s, the concerns about profligate spending are real. That begs the question of whether European equities are a good buy-the-dip opportunity. Valuations are so much lower than in the U.S., but is that enough?
Political Landscape
Earlier this month, votes in the European Parliament reflected a significant move to the right, with voters in France, Italy, Austria, and Germany affording the far-right center parties a significant majority. French President Emmanuel Macron wasted no time announcing a “snap” election as he dissolved the French Parliament and called for elections for the lower house of Parliament to be held in two rounds on June 30 and July 7 — this Sunday and the next.
Given the landslide victory for Marine Le Pen’s National Rally Party, Macron's call for a snap election is considered a major gamble as it is seen as a referendum on not only Macron's leadership but on the political, social, and economic status quo. The latest polls show Macron losing to the far-right coalition, led by Le Pen, as well as a coalition from the left.
Italy has provided a model for cobbling together a functional government amid the rise of Georgia Meloni’s right-wing alliance two years ago, which could help calm some fears among market participants. For markets, the primary concern in France is a lack of budget discipline. But more broadly, we know markets don’t like uncertainty, so more volatility in European markets in the near term is to be expected. A strong U.S. dollar is a natural consequence and could add an additional headwind.
Political Uncertainty Has Left European Valuations More Attractive
Valuations are quite attractive in Europe, as they have been for quite some time. Japanese stocks are also cheap, but Europe’s are even cheaper right now, at a price-to-earnings ratio (P/E) of 13.5. Not only are European equities currently priced 36% below the S&P 500, but the P/E is 5% below its 10-year average. But these valuations aren’t as cheap as they appear relative to the U.S., given the significant innovation advantage enjoyed by the U.S. and the makeup of the respective indexes (more on that below).
It will take more than just attractive valuations for Europe to work. As Europe's economic activity potentially picks up as rate cuts take hold and inflation potentially eases further, these valuations could expand. An end to the war in Ukraine and the start of the rebuilding there would help, as would greater political stability.
Europe is Even More Attractively Valued Than Japan
Source: LPL Research, FactSet, 06/24/24
Disclosures: Indexes are unmanaged and cannot be invested in directly. Past performance is no guarantee of future results. Estimates may not materialize as predicted.
European Earnings Growth is Not Keeping Up
We acknowledge the opportunity is there for some valuation expansion in Europe, but earnings are a key piece of the equation. When we compare European earnings to U.S., they simply fall short. A lot of that can be explained by the fact that the MSCI Europe Index holds less than 10% in technology and digital media stocks, compared to over 40% for the S&P 500.
Europe's earnings are improving some and are likely to be respectable this year and next, but they will likely lag at least a few points behind growth in the U.S. We won’t go so far as to say that U.S. valuations are justified, but much of the valuation gap between the U.S. and Europe is likely given the earnings growth advantage the U.S. enjoys, magnified by significantly higher weightings in the most profitable tech companies.
U.S. Earnings Growth Expected to Far Outpace Europe's
Estimates May Not Come Through But Japan's Outlook Also Looks Better
Source: LPL Research, FactSet 06/25/24
Disclosures: Indexes are unmanaged and cannot be invested in directly. Past performance is no guarantee of future results. Estimates may not materialize as predicted.
Europe Doesn’t Stand Out Based on Our Technical Analysis Work
European equities are participating in the bull market but not leading it. The MSCI Europe Index has climbed steadily higher after breaking out from a year-long consolidation range earlier this year. While the index has pulled back modestly this month, demand has picked up near support from the 50-day moving average (dma). Participation in the record-high rally has also been widespread, with around three-quarters of constituents trading above their 200-dma. Despite the constructive technical setup, relative strength in Europe continues to fade. The MSCI Europe Index vs. S&P 500 ratio chart recently dropped to record lows after violating key support off the January lows.
Europe is Participating in the Bull Market, But Not Leading
Source: LPL Research, Bloomberg 06/26/24
Don’t Get Too Excited About More ECB Rate Cuts
Europe cut rates by 0.25% on June 6, beating the Federal Reserve (Fed) to the punch. Rates in Europe are lower than in the U.S., a slight positive when choosing between European and U.S. equities, but the outlook for rate cuts from the two central banks going forward is actually identical. We also know stocks historically do not do as well during cutting campaigns as they do during pauses (because cuts are typically aligned with economic weakness). This time could be different, and the odds that the ECB cuts again before the Fed could be more than 50%, but that is hardly enough to favor European equities over the U.S.
Following ECB Rate Cut Number One, Expectations Are Similar to the Federal Reserve
Source: LPL Research, Bloomberg 06/25/24
Disclosures: Past performance is no guarantee of future results. Estimates may not materialize and are subject to change.
Conclusion
With attractive valuations and perhaps more political stability than the initial market reaction implied, investing in Europe does make sense. But with slower earnings growth, less exposure to powerful trends in technology such as AI, and weak relative strength, the case for European equities over the U.S. is tough to make. Still, we think the outlook is good enough for an allocation near neutral. The Strategic and Tactical Asset Allocation Committee (STAAC) recommends a neutral allocation to developed international equities, with a slight preference for Japan over Europe, and remains overweight in U.S. equities.
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