Have US equities finally peaked relative to European equities?

European equities reached its peak outperformance against US equities around the end of 2007 but since then the fortunes have changed. US equities are up 140% and European equities are down 4%  in USD terms. Two major events happened in the subsequent period. The trade-weighted real USD rose 28% adding tailwind for US assets relative to non-US assets and the technology sector went through a massive boom through search engines (online advertising), smartphones, social media, video streaming, cloud-based application software, cloud-based infrastructure, machine learning and its related chip infrastructure, e-commerce platforms and online shopping. The US had the upper hand in the recent technology boom with Silicon Valley financing technology ventures that managed to gain wide dominance before Europe’s fragmented technology hubs could come up with alternatives. Many of these emerging technologies had economics of scale that had not been seen since the 1960s industrial boom and the 1980s energy boom. European equity markets were basically living in the past. A final important driver was that US companies were in general net buyers of their own shares where European companies continued to be net issuer of equity capital.

The table above shows the changes in sector weights for S&P 500 and STOXX 600 since December 2007. While the collapse in the US energy sector has been significant it has been outweighed by the rise in technology (Microsoft and Apple), consumer discretionary (Amazon) and communications (Facebook and Alphabet). The biggest losing sector in Europe has been the financials which were dominant in 2007, but is still the largest sector, but has since lost its profitability as the Euro crisis and wrong policies have made it difficult to operate banks. Europe’s two biggest winners have been health care stocks and consumer staples and here lies some of the future potential.

What is the case for being positive and overweight European equities? Valuation is much better on European equities with a forward dividend yield of 2.8% and dividend futures expecting annualized dividend growth of 0.6% until 2023. On top of that the P/E multiple is lower on European equities relative to US equities so European equities could get a relative better P/E multiple over the coming years. US equities are currently priced with a forward dividend yield of 1.7% and dividend futures expecting negative 3.3% annualized dividend growth until 2023. This means that US equities need P/E multiple expansion much more than European equities to continue to deliver outperformance. That’s going to be difficult.

In the case economic activity is subdued globally the coming years European equities offer more defensive characteristics with a higher weight on consumer staples, health care and utilities. Europe is leading on the green transformation and here lies another upside through the industrials and utilities sectors. With only 7.5% of European equities in the technology sector there’s also room for a higher weight over time which will improve the growth profile of European equity markets. Finally with Europe’s large health care share and the increased focus on drug discovery and health care equipment after COVID-19 Europe does have an edge.