US vs. Europe: A Closer Look at US Outperformance

 “Europe was created by history. America was created by philosophy.” – Margaret Thatcher

“In America everything goes and nothing matters, while in Europe nothing goes and everything matters.” – Philip Roth, American novelist and modern literary great

MSCI Europe Index vs. S&P 500 Index – Total Return in USD Indices TRSource: Bloomberg

In the ten years since the global financial crisis, European stocks have underperformed US stocks by a considerable margin.

In the first three years following the global financial crisis, the performance of the two markets were not too dissimilar. For the period commencing end of November 2008 through October 2011, the MSCI Europe and S&P 500 indices generated total returns of 46 and 53 per cent in US dollar terms, respectively.

Since late 2011, however, investors in European stocks have been left frustrated all the while investors in US stocks have enjoyed a long-running bull market. From 29 October 2011 through 20 November 2018, the MSCI Europe Index has generated a total return of 35.8 per cent in US dollar terms – 102.8 per cent less than the total return of the S&P 500 Index for the same period.

Despite, the strong outperformance of US equity markets relative to European equity markets, European stocks have been more expensive, on a trailing 12 month price-to-earnings basis, for the majority of the time since late 2011. Only since late 2017 have European equities become cheaper than US equities on a trailing 12 month price-to-earnings basis.

MSCI Europe vs. S&P500: Trailing 12 Month Price-to-Earnings RatioIndices PESource: Bloomberg

At an index level and since the global financial crisis, US companies have grown revenues and earnings at a faster clip than their European companies.

MSCI Europe vs. S&P500: Revenue Growth RevenueSource: Bloomberg

MSCI Europe vs. S&P500: Earnings Growth EarningsSource: Bloomberg

In terms of annual performance, European markets have outperformed US markets in three out of the nine calendar years since the global financial crisis: 2009, 2012, and 2017. Notably, in 2009 and 2017, European companies’ year-over-year earnings growth rates were far superior to those of American companies. While outperformance in 2012, can be attributed to Signor Draghi uttering those famous words that brought Europe back from the brink: “Whatever it takes”.

European earnings also outpaced US earnings during the years 2010 and 2013, yet US stocks outperformed European stocks. The year 2010 was, of course, when the sovereign debt crisis engulfed the peripheral members – Portugal, Italy, Ireland, Greece and Spain – of the European Monetary Union. While in 2013, although European equities underperformed US equities , it was still a very good year for Europe with the MSCI Europe Index generating a total return of around 23 per cent in US dollar terms versus around 28 per cent for the S&P 500 Index.

Digging a little deeper we compare the performance between US and European markets on a sector-by-sector basis, using the Global Investment Classification Standards (GICS) level 1 classifications.

US vs. Europe: 5- and 10-Year Sector Level Total Returns (USD) Sectors TR

Source: Bloomberg

Note: Periods ending 31 Oct 2018, calculated using monthly data, and excludes real estate

For both the 5- and 10-year periods for every sector except energy, US performance has been superior to European performance – we have excluded real estate as we were unable to gather clean data for the sector.

The US energy sector has lagged the European energy sector largely due to the much higher number of listed shale oil companies in the US. Shale oil plays witnessed significantly larger drawdowns as compared to blue chip oil producers following the sharp drop in oil prices in late 2014.

For the 10-year period ended 31 October 2018, the greatest difference in performance between the two markets comes from the consumer discretionary and information technology sectors. The consumer discretionary sector includes Amazon and used to include Netflix – a significant portion of US consumer discretionary outperformance can be attributed to Amazon and Netflix. While the outperformance of the American information technology sector has been broader than that of the consumer discretionary sector, a handful of stocks still have had an outsized impact on US outperformance. These stocks are namely Apple, Google, Facebook, Salesforce.com, Microsoft and Nvidia. (Note: In January 2018 the industry classification of Google, Facebook, and Netflix was changed to communication services).

The most comparable performance between the two markets, for the 10-year period, comes from the energy, materials, consumer staples and industrial sectors.

US vs. Europe: 5-Year Sector Level Revenue and Earnings Growth Sectors Rev Earnings

Source: Bloomberg

The above table details the 5 year (4-years for communication services) revenue and earnings growth by sector for US and European stocks.

Notably, in the US, net margins expanded from 2012 through 2017 across all sectors except energy. While in Europe, margins expanded for six sectors and declined for three – margins declined for the consumer discretionary, utilities and communication services sectors.

Median sector level revenue growth in the US for the five-year period was 20.96 per cent versus -2.26 per cent in Europe. (Earnings level comparisons are not meaningful in our opinion due to the artificially high earnings growth in certain sectors in Europe due to write-downs / exceptional circumstances in 2012 that understate earnings at the beginning of the period.)

Investment Perspective

The underperformance of European equities relative to US equities over the last five- and ten-years can predominantly be explained by fundamental factors. The challenge at this juncture, however, becomes that of identifying scenarios under which European stocks would arrest this trend of underperformance and begin outperforming the US stocks on a prolonged basis. We outline three such scenarios below.

  1. If the next ten years are not like the last ten years

If we assume, simplistically and without trying to predict how, that the next ten years will be unlike the last ten years then there should be a preference for non-US stocks over US stocks in general.

In capital markets dominated by passive allocations to market capitalisation weighted indices, the main drawback is that the allocation to ‘go-go’ stocks is at its highest when they are at their peak relative to other stocks in the indices.

With respect to the S&P 500 Index, the information technology, healthcare, financials, communication services and consumer discretionary sectors have gone from representing 58 per cent of the index at the start of 2009 to almost 70 per cent today. And within these sectors the increase in allocation to technology and technology related stocks has been even more pronounced.

S&P 500 Index Allocation by GICS Level 1SPXSource: Bloomberg

The change in sector allocation for US indices has been far more prominent than it has been for European indices – simply because the dispersion in performance between sectors has been much greater in the US. Over the last ten-years the top performing sector in the S&P 500 Index has outperformed the median sector by almost 260 per cent. In comparison, the total return differential between the best performing and median sectors is 63 per cent for the MSCI Europe Index.

MSCI Europe Index Allocation by GICS Level 1 MSCIESource: Bloomberg

  1. Labour not capital is rewarded

“The defining characteristic of economics in the 1950s is that the country got rich by making the poor less poor.

Average wages doubled from 1940 to 1948, then doubled again by 1963.

And those gains focused on those who had been left behind for decades before. The gap between rich and poor narrowed by an extraordinary amount.”

– Excerpt from Morgan Housel’s piece How This All Happened:

In the aftermath of the global financial crisis, unemployment levels shot up across the world. The global economy has spent the last ten-years healing from the damage wrought by the financial crisis. Slack in the labour market has been slow to dissipate and wages have remained stubbornly stagnant.

The corollary of the abundance of labour has been capital owners benefiting at the expense of labour.

As the global economy has healed, unemployment levels have gradually declined and wage pressures have slowly emerged. The European labour market, however, has much more slack than the US labour market – where unemployment levels are reaching twenty year lows and wage pressures are much more significant.

If demand for labour picks up globally, Europe has much more room to reduce unemployment levels before wages have to pick up meaningfully. Whereas the US has limited, if any, room for unemployment levels to drop lower without a meaningful increase in wage inflation. Therefore, Europe has greater flexibility to facilitate an improvement in household earnings without it impacting profit margins.

  1. Capital investment / infrastructure spending pick ups

US corporations have been far savvier capital allocators than their transatlantic counterparts – they have reduced equity, through share buy backs, and increased leverage during a time when servicing debt has never been easier. The behaviour of US corporations has been facilitated not only by record low interest rates but also by a limited need for capital investment – a deflationary environment incentivises the postponement of capital investment.

If capital investment picks up globally – motivated by inflation, infrastructure development led diplomacy, such as China’s Belt and Road Initiative, or a need to reconfigure global supply chains due to trade wars – European indices, with their much greater weighting to the industrial and materials sectors, are better placed to outperform the more technology leaning US indices in such a scenario.

Moreover, increasing capital investment may spur demand for credit in Europe and support the much maligned European financial services sector, which also happens to be the sector with the highest allocation in the MSCI Europe Index.

This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.

Don’t wait for the US Dollar Rally, its Already Happened

 

“Don’t cry because it’s over. Smile because it happened.” – Dr Seuss

 

“Republicans are for both the man and the dollar, but in case of conflict the man before the dollar.” – Abraham Lincoln

 

“Dark economic clouds are dissipating into an emerging blue sky of opportunity.” – Rick Perry

 

According to the minutes of the Fed’s June meeting, released on Thursday, some companies indicated they had already “scaled back or postponed” plans for capital spending due to “uncertainty over trade policy”. The minutes added: “Contacts in the steel and aluminum industries expected higher prices as a result of the tariffs on these products but had not planned any new investments to increase capacity. Conditions in the agricultural sector reportedly improved somewhat, but contacts were concerned about the effect of potentially higher tariffs on their exports.”

Despite the concerns around tariffs, the minutes also revealed that the Fed remained committed to its policy of gradual rate hikes and raising the fed funds rate to its long-run estimate (or even higher): “Participants generally judged that…it would likely to be appropriate to continue gradually raising the target rate for the federal-funds rate to a setting that was at or somewhat above their estimates of its longer-run level by 2019 or 2020”.

The somewhat hawkish monetary policy stance of the Fed combined with (i) expectations of continued portfolio flows into the US due to the interest rate differentials between the US and non-US developed markets, (ii) fears of the Trump Administration’s trade policies causing an emerging markets crisis, and (iii) the somewhat esoteric risk of ‘dollar shortage’ have led many to conclude that the US dollar is headed higher, much higher.

Of all the arguments for the US dollar bull case we consider the portfolio flows into the US to be the most pertinent to the direction of the greenback.

According to analysis conducted by the Council of Foreign Relations (CFR) “all net foreign demand for ‘safe’ US assets from 1990 to 2014 came from the world’s central banks”. And that “For most of the past 25 years, net foreign demand for long-term U.S. debt securities has increased in line with the growth in global dollar reserves.”  What the CFR has described are quite simply the symptoms of the petrodollar system that has been in existence since 1974.

Cumulative US Current Account Deficit vs. Global Foreign Exchange Holdings1aSources: Council on Foreign Relations, International Monetary Fund, Bureau of Economic Analysis

 

In recent years, however, global US dollar reserves have declined – driven by the drop in the price of oil in late 2014 which forced the likes of Norges Bank, the Saudi Arabian Monetary Agency, and the Abu Dhabi Investment Authority to draw down on reserves to make up for the shortfall in state oil revenues – yet the portfolio flows into the US continued unabated.

Using US Treasury data on major foreign holders of Treasury securities as a proxy for foreign central banks’ US Treasury holdings and comparing it to the cumulative US Treasury securities issuance (net), it is evident that in recent years foreign central banks have been either unable or unwilling to finance the US external deficit.

Cumulative US Marketable Treasury Issuance (Net) vs. US Treasury Major Foreign Holdings1Sources: US Treasury, Securities Industry and Financial Markets Association

 

Instead, the US has been able to fund its external deficit through the sale of assets (such as Treasuries, corporate bonds and agency debt) to large, yield-starved institutional investors (mainly pension funds and life insurers) in Europe, Japan and other parts of Asia. The growing participation of foreign institutional investors can be seen through the growing gap between total foreign Treasury holdings versus the holdings of foreign central banks.

US Treasury Total Foreign Holdings vs. US Treasury Major Foreign Holdings2Source: US Treasury

 

Before going ahead and outlining our bearish US dollar thesis, we want to take a step back to understand how and why the US was able to finance its external deficit, particularly between 2015 and 2017, despite the absence of inflows from its traditional sources of funding and without a significant increase in its cost of financing. This understanding is the key to the framework that shapes our expectations for the US dollar going forward.

We start with Japan. In April 2013, the Bank of Japan (BoJ) unveiled a radical monetary stimulus package to inject approximately US dollars 1.4 trillion into the Japanese economy in less than two years. The aim of the massive burst of stimulus was to almost double the monetary base and to lift inflation expectations.

In October 2014, Governor Haruhiko Kuroda shocked financial markets once again by announcing that the BoJ would be increasing its monthly purchases of Japanese government bonds from yen 50 trillion to yen 80 trillion. And just for good measure the BoJ also decided to triple its monthly purchases of exchange traded funds (ETFs) and real estate investment trusts (REITs).

Staying true to form and unwilling to admit defeat in the fight for inflation the BoJ also went as far as introducing negative interest rates. Effective February 2016, the BoJ started charging 0.1 per cent on excess reserves.

Next, we turn to Europe. In June 2014, Señor Mario Draghi announced that the European Central Bank (ECB) had taken the decision to cut the interest rate on the deposit facility to -0.1 per cent. By March 2016, the ECB had cut its deposit facility rate three more times to take it to -0.4 per cent. In March 2015, the ECB also began purchasing euro 60 billion of bonds under quantitative easing. The bond purchases were increased to euro 80 billion in March 2016.

In response to the unconventional measures taken by the BoJ and the ECB, long-term interest rates in Japan and Europe proceeded to fall to historically low levels, which prompted Japanese and European purchases of foreign bonds to accelerate. It is estimated that from 2014 through 2017 Japanese and Eurozone institutional investors and financial institutions purchased approximately US dollar 2 trillion in foreign bonds (net). During the same period, selling of European fixed income by foreigners also picked up.

As the US dollar index ($DXY) is heavily skewed by movements in EURUSD and USDJPY, the outflows from Japan and Europe into the US were, in our opinion, the primary drivers of the US dollar rally that started in mid-2014.

US Dollar Index3Source: Bloomberg

 

In 2014 with Japanese and European outflows accelerating and oil prices still high, the US benefited from petrodollar, European and Japanese inflows simultaneously. These flows combined pushed US Treasury yields lower and the US dollar sharply higher. The strong flows into the US represented an untenable situation and something had to give – the global economy under the prevailing petrodollar system is simply not structured to withstand a strong US dollar and high oil prices concurrently. In this instance, with the ECB and BoJ staunchly committed to their unorthodox monetary policies, oil prices crashed and the petrodollar flows into the US quickly started to reverse.

Notably, the US dollar rally stalled and Treasury yields formed a local minimum soon after the drop in oil prices.

US 10-Year Treasury Yield4Source: Bloomberg

 

Next, we turn to China. On 11 August 2015, China, under pressure from the Chinese stock market turmoil that started in June 2015, declines in the euro and the Japanese yen exchange rates and a slowing economy, carried out the biggest devaluation of its currency in over two decades by fixing the yuan 1.9 per cent lower.  The Chinese move caught capital markets by surprise, sending commodity prices and global equity markets sharply lower and US government bonds higher.

In January 2016, China shocked capital markets once again by setting the official midpoint rate on the yuan 0.5 per cent weaker than the day before, which took the currency to its lowest since March 2011. The move in all likelihood was prompted by the US dollar 108 billion drop in Chinese reserves in December 2015 – the highest monthly drop on record.

In addition to China’s botched attempts of devaluing the yuan, Xi Jinping’s anti-corruption campaign also contributed to private capital fleeing from China and into the US and other so called safe havens.

China Estimated Capital Outflows5Source: Bloomberg

 

The late Walter Wriston, former CEO and Chairman of Citicorp, once said: “Capital goes where it is welcome and stays where it is well treated.” With the trifecta of negative interests in Europe and Japan, China’s botched devaluation effort and the uncertainty created by Brexit, capital became unwelcome in the very largest economies outside the US and fled to the relative safety of the US. And it is this unique combination, we think, that enabled the US to continue funding its external deficit from 2014 through 2017 without a meaningful rise in Treasury yields.

Moreover, in the absence of positive petrodollar flows, we suspect that were it not for the flight to safety driven by fears over China and Brexit, long-term Treasury yields could well have bottomed in early 2015.

 

Investment Perspective

 

  1. Foreign central banks show a higher propensity to buy US assets in a weakening US dollar environment

 

Using US Treasury data on major foreign holders of Treasury securities as a proxy for foreign central banks’ US Treasury holdings, we find that foreign central banks, outside of periods of high levels of economic uncertainty, have shown a higher propensity to buy US Treasury securities during phases of US dollar weakness as compared to during phases of US dollar strength.

Year-over-Year Change in Major Foreign Holdings of Treasury Securities and the US Trade Weighted Broad Dollar Index 6Sources: US Treasury, Bloomberg

 

The bias of foreign central banks, to prefer buying Treasury securities when the US dollar is weakening, is not a difficult one to accept. Nations, especially those with export oriented economies, do not want to see their currencies rise sharply against the US dollar as an appreciating currency reduces their relative competitiveness. Therefore, to limit any appreciation resulting from a declining US dollar, foreign central banks are likely to sell local currency assets to buy US dollar assets. However, in a rising US dollar environment, most foreign central banks also do not want a sharp depreciation of their currency as this could destabilise their local economies and prompt capital outflows. And as such, in a rising US dollar environment, foreign central banks are likely to prefer selling US dollar assets to purchase local currency assets.

 

  1. European and Japanese US treasury Holdings have started to decline

 

European and Japanese US Treasury Holding 7Source: US Treasury

 

The ECB has already scaled back monthly bond purchases to euro 30 billion and has outlined plans to end its massive stimulus program by the end of this year. While BoJ Governor Haruhiko Kuroda in a testimony to the Japanese parliament in April revealed that internal discussions were on going at the BoJ on how to begin to withdraw from its bond buying program.

In anticipation of these developments and the increased possibility of incurring losses on principal due to rising US inflation expectations, it is likely that European and Japanese institutional investors and financial institutions have scaled back purchases of US dollar assets and even started reducing their allocations to US fixed income.

 

  1. Positive correlation between US dollar and oil prices

 

One of the surprises thrown up by the markets this year is the increasingly positive correlation between the US dollar and the price of oil. While the correlation may prove to be fleeting, we think there have been two fundamental shifts in the oil and US dollar dynamic that should see higher oil prices supporting the US dollar, as opposed to the historical relationship of a strengthening US dollar pressuring oil prices.

The first shift is that with WTI prices north of US dollar 65 per barrel, the fiscal health of many of the oil exporting nations improves and some even begin to generate surpluses that they can recycle into US Treasury securities. And as oil prices move higher, a disproportionality higher amount of the proceeds from the sale of oil are likely to be recycled back into US assets. This dynamic appears to have played out to a degree during the first four months of the year with the US Treasury securities holdings of the likes of Saudi Arabia increasing. (It is not easy to track this accurately as a number of the oil exporting nations also use custodial accounts in other jurisdictions to make buy and sell their US Treasury holdings.)

WTI Crude vs. US Dollar Index8Source: Bloomberg

 

The second shift is that the US economy no longer has the same relationship it historically had with oil prices. The rise of shale oil means that higher oil prices now allow a number of US regions to grow quickly and drive US economic growth and job creation. Moreover, the US, on a net basis, spends much less on oil (as a percentage of GDP) than it has done historically. So while the consumers may take a hit from rising oil prices, barring a sharp move higher, the overall US economy is better positioned to handle (and possibly benefit from) gradually rising oil prices.

 

  1. As Trump has upped the trade war rhetoric, current account surpluses are being directed away from reserve accumulation

 

Nations, such as Taiwan and the People’s Republic of Korea, that run significant current account surpluses with the US have started to re-direct surpluses away from reserve accumulation (i.e. buying US assets) in fear of being designated as currency manipulators by the US Treasury. The surpluses are instead being funnelled into pension plans and other entitlement programs.

 

  1. To fund its twin deficits, the US will need a weaker dollar and higher oil prices

 

In recent years, the US current account deficit has ranged from between 2 and 3 per cent of GDP.

US Current Account Balance (% of GDP)9Source: Bloomberg

 

With the successful passing of the Trump tax plan by Congress in December, the US Treasury’s net revenues are estimated to decrease by US dollar 1.5 trillion over the next decade. While the increase in government expenditure agreed in the Bipartisan Budget Act in early February is expected to add a further US dollar 300 billion to the deficit over the next two years. The combined effects of these two packages, based on JP Morgan’s estimates, will result in an increase in the budget deficit from 3.4 per cent in 2017 to 5.4 per cent in 2019. This implies that the US Treasury will have to significantly boost security issuance.

Some of the increased security issuance will be mopped by US based institutional investors – especially if long-term yields continue to rise. US pension plans, in particular, have room to increase their bond allocations.

US Pension Fund Asset Allocation Evolution (2007 to 2017) 10Source: Willis Tower Watson

 

Despite the potential demand from US based institutional investors, the US will still require foreign participation in Treasury security auctions and markets to be able to funds its deficits. At a time when European and Japanese flows into US Treasuries are retreating, emerging market nations scrambling to support their currencies by selling US dollar assets is not a scenario conducive to the US attracting foreign capital to its markets. Especially if President Trump and his band of trade warriors keep upping the ante in a bid to level the playing field in global trade.

Our view is that, pre-mid-term election posturing aside, the Trump Administration wants a weaker dollar and higher oil prices so that the petrodollars keep flowing into US dollar assets to be able to follow through on the spending and tax cuts that form part of their ambitious stimulus packages. And we suspect that Mr Trump and his band of the not so merry men will look to talk down the US dollar post the mid-term elections.

 

 

This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.