Tuesday 23 July 2019

David Fahy: 'Jury still out on European and US stocks as global recession looms'


A trader works on the floor of the New York Stock Exchange
A trader works on the floor of the New York Stock Exchange

Investor: David Fahy

During the best part of the noughties, European stocks outstripped their US peers. However, since the global financial crisis of 2008, there has been a distinct divergence in the opposite direction.

As we entered 2018, investors were becoming increasingly optimistic on the outlook for Europe, which was trading at its cheapest discount to its US peers in recent history. Unfortunately, the much anticipated European rally failed to come to fruition.

There are a myriad structural factors that have led to this long-term underperformance - including the superiority of the US business sectors, the economic backdrop, central bank policy and geopolitics.

To analyse the discrepancy between the two regions, we must first look at a factor which is often overlooked: the breakdown of companies and their respective sectors.

Over the past 10 years, the US stock market's exposure has steadily trended toward higher-growth, higher-profitability sectors - no more so than the technology sector, which now represents about 25pc of the Standard & Poor 500 (S&P 500).

The technology companies of the S&P 500, led by the FAANGs (Facebook, Amazon, Apple, Netflix and Google) has made returns of almost 500pc since 2009.

Compare this to European stock markets, whose largest sector is the traditional economy. Financial stocks represent 20pc of the European stock market. This low-growth, low-profitability sector has had a torrid time over the past few years. Lower interest rates, anaemic credit growth and heightened regulations have seen bank stocks remain at the same level as they were at five years ago.

The second factor is the relationship between economic growth, corporate profits and subsequent equity returns. In theory, as the economy grows, corporate earnings should increase. Over the past eight years, European and US gross domestic product (GDP) growth has averaged 1.4pc and 2.2pc respectively - predominately due to structurally higher productivity in the US. Traditionally, there is a close correlation in the direction of the two regions - with the European business cycle lagging the US cycle.

Over the past nine years, this relationship has significantly broken down three times. Then 2012 saw the European debt crisis. The US economy faltered in 2016. In 2018, the European economy slowed while the US economy maintained strength.

In the final two quarters of 2017, the eurozone achieved 2.8pc and 2.7pc annualised growth, leading equity investors' confidence in European stock markets to grow entering 2018. This was supported by the accommodative monetary policy of the European Central Bank (ECB) - where it stimulated the economy by holding interest rates negative and buying $30bn (€26.5bn) worth of bonds every month.

Meanwhile, the US Federal Reserve was attempting to avert an overheating economy by normalising its monetary policy, having ended its bond-buying programme and gradually raising interest rates. Up until the end of May last year, both US and European stock markets were performing roughly in line. However in the background, European economic data began to weaken and our fourth factor, geopolitics, came to the fore.

The tariff agenda of the US President Donald Trump both on China and Europe saw sentiment toward European equities take a turn for the worse. Fears over the future growth of China began to affect the outlook for European companies, which are more internationally exposed than their US counterparts.

At the same time, more idiosyncratic political issues began to weigh on Europe as Italian elections saw populist parties take control of parliament, Brexit was far from a resolution and a debt crisis in Turkey loomed.

Looking towards the end of the year, it is hard to ignore the continued slowdown of European growth, outstanding geopolitical issues and the potential troublesome elections across numerous nations. However, prudent policy from the ECB, a pick-up in global growth and an easing of the aforementioned headwinds should be more than sufficient to revitalise the economy.

The US economy, supported by a turnaround in policy from the Federal Reserve and by its corporate-friendly president, should continue to perform for the best part of the year.

Yet past 2019, a potential recession looms. Either way, with global markets becoming increasingly integrated, equities in both regions will likely move in the same direction.

  • David Fahy is a research analyst with Cantor Fitzgerald (www.cantorfitzgerald.ie)
  • Any investment commentary in this column is from the author directly and should not be seen as a recommendation from The Sunday Independent

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