Apart from the soaring euro, European investors could scarcely wish for a better economic backdrop.
It’s one reason why investors will keep tabs on what European Central Bank president Mario Draghi says in his speech at the Jackson Hole Economic Symposium on Friday. Those listening for clues as to whether the bank may delay policy tightening, particularly bond buying, look set for disappointment though. Unofficial comments downplay chances that Draghi’s speech, scheduled for 8pm London time, will address policy. That could leave anxieties over the single currency intact. Such worries began to clip the wings of Europe’s benchmark index in the spring and it has underperformed the S&P 500 since then.
Figure 1: STOXX Europe 600 vs. S&P 500, year to date, rebased
Source: Thomson Reuters and City Index
EU vs. EM
Contrary to widespread perceptions however, the galloping euro hasn’t affected growth yet. That’s despite reaching its the highest against the dollar in three weeks at the time of writing and just 140 odd points off October’s seven-year high against sterling. Recent data still showed Q2 Eurozone growth met expectations, with the best rise in five years. GDP rose by an annualised 2.1% and, 0.6% on the quarter. Net trade did weigh on Germany’s GDP, but more via rising imports, mainly driven by domestic demand. True, much of the euro’s 8% trade-weighted rise this year was over the last two months, so the pace of trade and overall growth will almost certainly moderate. But after this week’s factory PMI hit an almost 90-month high, a severe pullback in exports in coming months would be surprising. We must also remember the higher importance of global demand to Eurozone exports, historically, compared to exchange rates.
It’s also worth noting that easing investor interest in the region is partly a function of demand for emerging market equities. Relative to U.S. stocks, demand for European equities is firmer. Bank of America Merrill Lynch reported on Friday that the Eurozone saw its first equity fund net outflow in seven weeks. U.S. funds notched their worst run of outflows since 2004. Emerging market equities continue to show the best cross-asset performance, returning 27.1% year-to-date in dollar terms.
CAPE of forlorn hope
It’s still intriguing however that European shares continue to broadly underperform the states, despite political turmoil and policy failure on Capitol Hill and stretched valuations. The cyclically adjusted price/earnings ratio currently shows the S&P 500 valuation at 29.95, a 17-year high, compared to just below 20 for Germany’s DAX. Both have risen by quite comparable rates since early 2013, Germany’s benchmark index from 14.4 and the U.S.’s from 23.7. But the S&P 500’s adjusted valuation is considered more problematic close to 30.
Unless President Donald Trump makes real headway into the year-end, valuation concerns will continue to haunt U.S. investors. On the other hand, given Europe’s economic strength it’s equally difficult to imagine the ECB delaying the inevitable for much longer. A signal on tapering remains likely at its September meeting or October at the latest. And with the euro widely forecast to clip earnings growth by as much 5%-8% this year, investors will be more cautious on European shares than earlier in the year. Eventually, European markets will habituate to the end of ‘lower for longer’, but that psychological process will take time, given how long cheap borrowing costs have lasted. European stock market underperformance relative to the U.S. looks baked-in for the rest of the year at least.