Morningstar's "Perspectives" series features investment insights from selected third-party contributors. Here Jonathan White and Alec Harper, Client Portfolio Management Team for AXA Rosenberg give their outlook for the US and Europe.
There has been much market commentary of late about the relative value of the US and Europe. For much of 2014, when we visited clients and investors across Europe there appeared to be a consensus that the US was expensive and Europe offered better value, particularly for asset allocators. And at the time we had to agree – traditional valuation metrics such as price/12-month trailing earnings (PE) were at levels not seen for some time. However, we believe that investors should be increasingly concerned by the lack of fundamental support to current valuations in Europe. We are not convinced that the ‘value’ in European equities is as apparent now as it was in 2014, as optimistic expectations are increasingly priced in.
Dealing with the US issue first, there is no doubt that valuations are at elevated levels. In May the S&P 500 Index recorded a PE of 18x earnings, a level last reached in November 2009.
The US has returned to growth more quickly than other major world economies and this has been, at least until 2015, reflected in the performance of the US stock market.
So What About Europe?
For the first time in nearly 13 years, European equity markets are trading effectively at par with the US. In our view this is a noteworthy event because structurally Europe should trade at a discount to the US. In part this is because of the tech effect; technology stocks make up some 20% of the US market; in Europe they are just over 9%. This difference means that US stocks, on average over time, have commanded a premium to Europe’s more traditional economy.
Indeed, the 30-year historic average premium the US market commands over Europe is around 10%. What’s interesting is that this premium has been entirely eroded in 2015, despite the gap being 16% at the end of 2014.
What is causing this? Put simply, investors are investing in the hope that Europe will grow rather than investing because it has shown evidence of growth. In part the ECB is to blame with its asset purchase programme; excess liquidity is lifting asset prices but fundamental problems persist at the heart of Europe, particularly as a ‘Grexit’ looks more possible now than it did 3 months ago.
Our biggest concern is that the rate of price change in Europe has been in the context of flat lining earnings. This is in stark contrast to the US, where earnings have, to some extent, justified the premium paid.
On a forward earnings basis European equites are trading at a slight discount to the US, but even this is pricing in consensus earnings growth of 7.6%. Our analysis indicates that for US and European valuations to return to more normal levels we would need to see some 14% growth in European earnings over the next 12 months to justify their current valuation. We are sceptical that this can be achieved.
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