The end of the American Dream ?
Laurent Denize, Global Co-CIO, ODDO BHF AM.
” We see catch-up potential for Europe given 1/ the improved economic activity, 2/ the increasingly likely ECB rate cut in June, 3/ the undemanding equity valuations, and 4/ the record valuation discount. For those reasons we tactically prefer European over US equities”
We must confess that we have a strategic “bias” in favor of the US market. The past 15 years proves us quite right. Since the end of the 2007-2008 Financial Crisis, Europe has outperformed for only 27 months, or just over 2 years. This structural outperformance of the US vs. Europe is mainly explained by a more robust EPS dynamic in the US. What about the last few months? Since the beginning of the year, EuroStoxx 50 has slightly outperformed the S&P500 and relatively good performance by the European market vs. the US market was achieved despite a rather unfavorable sector mix. Does this spell the end of the “American Dream”? Clearly not, but it does point to the need to reconsider Europe…at least tactically.
SOME ROADS LEAD TO EUROPE
Improved economic activity and more positive surprises for Europe than for US
We expect growth to pick up with economic surprises now positive in the Euro Zone. In contrast to the US, the Economic Surprise Index for the Eurozone has been on an upward trajectory since November 2023 reaching levels suggesting that economic releases have been consistently surpassing expectations. In the meantime, we see Europe benefiting from a pick-up in PMIs and in particular an upswing in the manufacturing cycle. To that extent, the composite Purchasing Managers’ Index (PMI) for the euro-zone recently climbed from 49.2 to 50.3, crossing into expansionist territory.
The ECB will not wait for FED to start the easing cycle
The disinflationary trend persists, and market expectations point to earlier rate cuts by the ECB than by the FED. After initiating its tightening cycle in mid-2022, the ECB is now poised to unwind its accommodative stance, starting with the June meeting. We anticipate three rate cuts in 2024 by the ECB (each at 25 basis points). Interestingly, this easing movement is likely to precede similar actions by the US Federal Reserve. The possibility of a June cut by the American counterparts, especially after stronger-than-expected labor data (April nonfarm payrolls at 303,000 versus an expected 214,000) and disappointing inflation prints, is now questioned by markets. Historically, equities have responded positively to rate cuts, particularly when no recession is imminent. Our call is that European stocks stand to benefit from this supportive monetary policy.
Too pessimistic earnings forecasts for Europe
2024 Earnings Per Share (EPS) estimates remain undemanding for Europe for both Q1 and FY. Although EPS revisions have been slightly negative for Europe since the beginning of the year, they seem to be stabilizing now. Q1 2024 estimates look for -11% over 1 year (but with a sequential increase of +5%, marking the first such uptick since 2022). It is undemanding and relatively subdued compared to the improving economic conditions. We believe mid- single-digit growth is achievable for FY 2024 given easy base effects, particularly for commodities, while near-trend GDP growth should preserve margins and top line. For those reasons, we expect further earning revisions after the Q1 earnings season.
Record Valuation Discount
European stocks currently trade at a deep discount to the US, far more than historically. The 12-month forward price-to-earnings ratio (P/E) stands at approximately 13x in Europe (5% below its mean since 2014), contrasting with around 21x in the US (70% above its mean since 2014). This remarkable relative difference (approximately 0.6 ratio) represents the lowest historical level. Some of this is AI-related, but the bigger gaps are found in sectors outside Technology, in areas like Financials, Energy and Consumer Discretionary. It is even more noteworthy that the gap remains even when sector-adjusting and even when adjusting for different growth prospects.
Higher Shareholder Yield for Europe
Dividend yield is the highest in the Eurozone (3.5% expected for 2024) with more eye-catching figures than in other markets, such as Japan (2.2%), US (1.5%), or Emerging Markets (3.2%). Buyback yield in Europe is also now close to US levels, at around 1.5%, signaling confidence from companies in their growth prospects. This high-income profile of European Equities strengthens the attractiveness of the geography.
Some technical factors lead to Europe
First, liquidity conditions favor European stocks. The ratio of market capitalization to money supply stands at an all-time high of 2.4 in the US, while it is only 0.6 in the Eurozone, or the lowest level among major stock markets. More liquidity will be able to move into stocks in Europe than in the US. Moreover, the ECB is slated to cut rates sooner (and probably more) than the FED this year, which will boost Europe’s liquidity conditions relative to those of the US. Second, investors are actively closing short positions in European stocks. Notably, the short loan value as a percentage of market capitalization for European stocks has reached its lowest level in the past decade. This trend reflects a growing sense of confidence in the region’s prospects.
WHAT ARE OUR FAVORITE SECTORS AND THEMES ?
Structural convictions: From a structural point of view, we continue to favor 3 sectors/themes in the European Equity universe
- Luxury: The luxury sector has experienced a significant recent de-rating driven by worries about China and future growth rates, but the anticipated recovery in the Chinese economy is expected to drive demand for luxury goods. For those reasons FY 2024 EPS revisions have now turned positive with strong underlying data in January and February and should benefit to higher quality names.
- Healthcare: We recommend being positioned on this high-quality defensive sector without having much consumer exposure to worry about. Additionally, Healthcare’s exposure to China’s growing pharma requirements is underappreciated and the fact that the sector has not done much in the past few months (excluding Novo Nordisk) strengthens our conviction.
- Technology: European tech companies share strong balance sheets and robust cash flow generation, supporting their growth prospects and justifying higher valuation levels. We keep advocating that longer-term secular trends towards Artificial Intelligence remain supportive.
Tactical convictions: Tactically, we favor some selective Value Cyclicals
- Banks: European banks are positioned for good profitability given soft landing, high yields, and low provision risk. Capital markets activity is expected to pick up, benefitting to investment banks. The valuation stays very cheap with high cash returns to shareholders, making Banks a tactical call for us.
- Chemicals: Benefiting from the highest earnings growth for 2024, Chemicals should benefit from global manufacturing PMIs picking up, lower energy prices, and the restocking cycle now excess inventories have been cleared.
- Energy: With improving economic conditions, energy companies may witness upgrades in earnings per share. Furthermore, OPEC+ production cuts and geopolitical risks have supported oil prices and energy stocks, making them an effective hedge against uncertainties at low price (P/E at 7.0x and yield > 10%).
CONCLUSION
We see catch-up potential for Europe given 1/ the improved economic activity, 2/ the increasingly likely ECB rate cut in June, 3/ the undemanding equity valuations, and 4/ the record valuation discount. For those reasons we tactically prefer European over US equities. However, if recent developments indicate that European equities may be poised for a more favorable trajectory, this temporary window should not blind us to the fact that Europe faces some structural challenges, preventing us from adopting a structural positive positioning on the geography. Structurally, the “American Dream” is not fading away and US should continue to surprise on the upside.
