Even though some European stocks are giving U.S. stocks a run for their money this year, investors still give the region’s companies a lower valuation than their counterparts across the Atlantic. However, some signs could change, according to Goldman Sachs Research.
The STOXX Europe 600 index is up about 8% and the DAX index of German stocks is up 14% in 2023, compared with a 12% gain for the U.S. S&P 500 index. But European stocks continue to rise ‘trade at a larger-than-normal discount to those in the United States, and European stocks change hands at around 13 times consensus forecast earnings, compared to around 19 times for their US counterparts. This reduction is the largest in more than a decade and well below the 20% median of the past 20 years.
The reasons go beyond the combination of dominant sectors in each region. While Europe has fewer technology companies that demand higher multiples from investors, every sector in Europe is currently trading at a discount to its counterpart in the United States, according to Sharon Bell, senior strategist at the European portfolio strategy team.
“This valuation gap has become very large and I think it’s undeserved,” Bell says. “There are different ways to narrow this gap over time.”
Bell says there are a number of reasons why US and European valuations are no longer in sync. The global financial crisis hit European financial indices particularly hard. Since then, booming investment in innovation and technology in the United States has allowed American companies to better take advantage of a period of low interest rates, pushing the market capitalization of U.S. stocks to 2.6 times that of those in Europe, the highest gap ever recorded. since the early 1980s. The US listed technology sector is 10 times larger than Europe’s – and this sector does not include mega-cap companies like Amazon, Meta or Tesla, which are listed in other sectors.
A smaller investor base in Europe has also contributed to this situation. Relative to the size of GDP, European stock markets tend to be smaller than those in the United States, largely due to the lack of depth of domestic investors. Europeans allocate more capital to housing and other investments than to stocks, compared to their U.S. counterparts, and stock allocations from pensions and insurance companies have declined sharply in recent years.
Even though these factors are entrenched, Bell believes the valuation gap between U.S. and European companies could soon narrow. She points to a handful of factors – including changing investor sentiment towards market risks, rising interest rates and the return of profit margins in the United States, as well as an improving regulatory environment. in Europe – which could push European stock prices higher and narrow the valuation gap.
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Higher interest rates in the United States: The U.S. market has benefited more than Europe from the rate cut given its larger share of technology and high-growth companies, but risks suffering more if rates remain high this cycle, as Bell and his team predict . Additionally, the U.S. private sector tends to be more vulnerable to rising lending costs given its lower savings rate and higher debt levels. Rising yields are also encouraging more U.S. investors to move their capital into money market funds.
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An improving regulatory and risk context: Rigorous stress tests, high capital ratios and other banking rules have made European banks more resilient. At the same time, European corporate tax rates have fallen. Additionally, sovereign credit risks in Europe appear to have diminished thanks to the European Central Bank’s commitment to dampening sovereign spreads through targeted asset purchases if the need arises.
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A more global representation: If investors seek to diversify further outside the United States, European companies will likely benefit. Overall, almost 60% of European companies’ sales are made outside Europe, compared to just 29% of U.S. companies’ exposure to non-U.S. markets. Companies listed in Europe are also more global than companies listed in other regions in terms of investment and assets, according to Goldman Sachs Research. Foreign investors are regular buyers of European stocks and fund flows have accelerated in recent years. Additionally, non-U.S. markets tend to perform better when the dollar is weakening and the dollar is overvalued based on long-term models.
- Reversion of the profit margin: Profit margins and the share of profits in GDP are both exceptionally high in the United States, and these high levels may not be sustained, Bell says. Labor groups in the United States, for example, are lobbying for a higher share of economic output. “The cake is not shared equally. In fact, it is particularly uneven at the moment and there is a growing risk that is not sustainable,” says Bell. The underperformance of European profits relative to those of US companies stopped around 2020, according to Goldman Sachs Research. The high share of European defensive growth companies and improving business models in banks, telecommunications and utilities boosted overall profits.
- Repurchases and repossessions: Share buybacks in Europe have reached multi-year highs as companies seek to improve their valuations by reducing the supply available to the public. This is particularly happening in the energy and financial sectors, where valuation gaps are widest compared to their U.S. counterparts. Takeover bids targeting European companies could also push up prices. Recent private equity deals in the UK highlight the potential for public equity to be privatized by global private equity investors with sufficient capital to deploy, according to Bell. “Foreigners are using their dollars to buy cheap European assets because they look cheap – that would drive up the valuation of European companies,” Bell says.
Taken together, these factors point to a more favorable outlook for European equity markets relative to those in the United States, according to Goldman Sachs Research, and our strategists predict that the STOXX Europe 600 will outperform the S&P 500 in 2023. “Even if the valuation gap does not narrow, Ultimately, the US is unlikely to continue to massively outperform Europe,” says Bell. “Investors are showing that they want to diversify their risks. And this will continue to benefit Europe.”
