European dawn?
European dawn?
The elevated valuations of US equities, in particular large cap technology stocks, pose a challenge to many investors. Over the past few years those valuations have been justified by the impressive earnings growth. In contrast, non-US equities have struggled to generate profits growth. However, in recent weeks the non-US profits backdrop has improved.
Through 2024, interest rates were cut by 1 percentage point in both the US and Europe. Interest rate cuts were supportive for equities in general, but especially for those with high valuations. In 2025, the path of interest rates is expected to diverge, with interest rates falling further and faster in Europe. In the US, it is possible that interest rates may not be cut until the end of 2025. The differing level of stimulus for the respective economies in coming months may be the source of difference for equity markets, especially given the different starting valuations.
Recent surveys also point to a better lending backdrop in Europe in 2025 than has been the case for a few years. Whether as a response to lower interest rates or a stabilisation of the wider economic environment, banks are reporting a pickup in demand for borrowing. Typically, this precedes faster lending growth and more robust economic activity.
The combination of more attractive valuations, an improvement in the relative backdrop for earnings and expectations for further interest rate cuts in Europe, means we see a better backdrop, for the time being, for European equities in comparison with US equities.
Away from the ‘normal’ discussions of valuations, earnings and interest rates, there is also geopolitics. Leaving aside both the morality and long-term geopolitical consequences, Trump’s ‘peace deal’ for Ukraine may deliver a positive surprise for risk assets and particularly, the European economy. One can envisage a ‘solution’ where Russian gas becomes more accessible to western Europe. In such a scenario the European economy may get a positive income shock reversing some of the negative energy price shock of 2022.
Finding hope in Europe
US equities have outperformed non-US equities for the past 15 years. Fundamentally the profits backdrop for US equities has been better than elsewhere. In addition, US equities have rerated (i.e. become more expensive). In 2015, the price-to earnings ratio for US equities was 16.6 times, i.e. you paid 16.6 times for each unit of profit). This has increased to 22.4 times. Over the same period, non-US valuations remain unchanged at 15 times. The combination of stronger profits and higher valuations has seen the US equity market grow to account for 66% of the overall global equity market.
US equity valuations have re-rated over time while valuations elsewhere haven’t risen over the last 10 years
Source: Bloomberg, Artorius
To date this has been justified (to some extent) by the stronger than expected profits growth from US equities. This has justified a full weighting to US equities in the past.
US equity performance versus the Rest of the World (RoW) appear to track relative earnings (Earnings per share ‘EPS’): with stronger US earnings driving higher relative to non-US equities
Source: Bloomberg, Artorius
However recent updates have seen non-US earnings start to outpace US earnings. And this is showing up in outperformance of non-US equities compared to US equities. If this continues then the long dominance of US equities versus all other equities may start to fade.
In recent weeks, non-US equities (Rest of the World) are outperforming as the relative earnings momentum has shifted away from the US equity market
Source: Bloomberg, Artorius
US interest rates may not fall in 2025
In 2024, a source of stimulus was interest rate cuts in both Europe and the US. This was expected to continue in 2025. However, on the back of better than expected economic growth and inflation remaining higher for longer, investors now expect US interest rates to be cut by only 0.25% towards the end of 2025. Meanwhile, European interest rates are expected to be cut by 0.75% which should aid the European economy.
Interest rates were cut in 2024 in both Europe and in the US. In 2025, interest rates are expected to fall further and faster in Europe than in the US
Source: Bloomberg, Artorius
Lending to recover
The European Central Bank (ECB) survey of European banks is reporting that demand for loans has started to recover, which typically leads to an economic acceleration. The survey of banks aims to capture their qualitative assessment of the borrowing backdrop in the economy. Similar to the Senior Loan Officer Survey in the US (which we have written about previously and is similarly upbeat about conditions in the US), the ECB survey shows a more upbeat environment than we’ve seen for the past few years. Lower interest rates in Europe appear to be leading to a greater demand for loans by companies and households.
European banks are reporting a sharp upturn in demand for borrowing, which historically leads to stronger lending growth and more robust economic conditions
Source: Bloomberg, Artorius
Given the widespread pessimism over the European economy, as reflected in the much lower valuations for European equities, upside surprises for the European economy may deliver upside surprises for European equities. In contrast, US equities appear to be priced for good news, and without the support of lower interest rates or better than expected earnings growth, may have to play second fiddle to other equity markets.
Leaving aside both the morality and long-term geopolitical consequences, Trump’s ‘peace deal’ for Ukraine may deliver a positive surprise for risk assets and the European economy particularly. One can envisage a scenario in which Russian gas becomes more freely available in Europe, and despite the moralistic hand wringing of political ‘leaders’, this would likely support further falls in European inflation. This would enable the ECB to cut rates by more than currently expected, which would support the European economy in coming months.
Conclusion
The elevated valuations of US equities, in particular large cap technology stocks, pose a challenge to many investors. Over the past few years those valuations have been justified by the impressive earnings growth. In contrast, non-US equities have struggled to generate profits growth. However, in recent weeks the non-US profits backdrop has improved.
Through 2024, interest rates were cut by 1 percentage point in both the US and Europe. Interest rate cuts were supportive for equities in general, but especially for those with high valuations. In 2025, the path of interest rates is expected to diverge, with interest rates falling further and faster in Europe. In the US, it is possible that interest rates may not be cut until the end of 2025. The differing level of stimulus for the respective economies in coming months may be the source of difference for equity markets, especially given the different starting valuations.
Recent surveys also point to a better lending backdrop in Europe in 2025 than has been the case for a few years. Whether as a response to lower interest rates or a stabilisation of the wider economic environment, banks are reporting a pickup in demand for borrowing. Typically, this precedes faster lending growth and more robust economic activity.
The combination of more attractive valuations, an improvement in the relative backdrop for earnings and expectations for further interest rate cuts in Europe, means we see a better backdrop, for the time being, for European equities in comparison with US equities.
Away from the ‘normal’ discussions of valuations, earnings and interest rates, there is also geopolitics. Leaving aside both the morality and long-term geopolitical consequences, Trump’s ‘peace deal’ for Ukraine may deliver a positive surprise for risk assets and particularly, the European economy. One can envisage a ‘solution’ where Russian gas becomes more accessible to western Europe. In such a scenario the European economy may get a positive income shock reversing some of the negative energy price shock of 2022.
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