Why European stocks are crushing US peers

CNN

By Julia Horowitz, CNN

For years, global investors preferred American stocks to European ones. But at a time of change in financial markets, favor is shifting.

On Friday the STOXX 50 index — which tracks Europe’s blue-chip firms — hit its highest level in 22 years. It has jumped 10.8% year-to-date. The region’s broader STOXX 600 index is up 9.9% so far this year.

By comparison, the Dow Jones Industrial Average in the United States has climbed 2%. The broader S&P 500 is 7.5% higher.

This year has seen a “significant outperformance of Europe” after a long stretch when it was “an unloved region,” said Richard Saldanha, lead manager for the Global Equity Income Fund at Aviva Investors.

Shares of LVMH, Europe’s most valuable company, reached at an all-time high this week after the luxury goods giant reported strong sales lifted by a rebound in China.

However, the conditions that have driven Europe’s winning streak are changing rapidly. Many investors are convinced the Federal Reserve could pause interest rate hikes soon as inflation in the United States falls and fragility in the banking sector increases the likelihood of recession later this year.

That raises questions about how long Europe’s dominance can last.

Why Europe is out front

When interest rates were at rock bottom, investors flocked to the US stock market to buy shares in the country’s technology companies including Apple, Amazon, Microsoft and Tesla. Those “growth” stocks gave investors a stake in firms that were on track to expand their businesses quickly and generate hefty returns.

But as borrowing costs have shot up, jeopardizing economic growth, expectations for future profits have been lowered and less risky investments have also started to offer tempting returns. Tech stocks have slumped as a result.

Now, investors are more drawn to “value” stocks: companies thought to be trading at a discount based on their financial performance. And that’s benefiting Europe.

The “low-interest-rate regime has changed, and that means there’s been a change in leadership away from the growth companies and more into value companies,” said Saldanha at Aviva Investors. “That really plays into Europe, which has always been more of a value market than the US.”

Despite concerns about the global banking sector following the failure of Silicon Valley Bank and emergency rescue of Credit Suisse last month, shares of European lenders — seen as “value” picks — have gained ground this year. Shares of Italy’s UniCredit are up more than 40% since the start of 2023, while Spain’s Banco Santander is almost 30% higher. US peers, meanwhile, have suffered losses.

Another reason for Europe’s outperformance has been the change in economic expectations around the start of the year. Investors had been bracing for a painful recession in the region as high energy prices hurt consumers and businesses.

Economic growth in the countries that use the euro flatlined in the final three months of 2022. But investors have been encouraged by a recent pullback in energy prices and signs of economic resilience in early 2023. The reopening of China’s economy has also been beneficial, since many European businesses are major exporters.

“The big energy-related recession in Europe wasn’t coming through. China’s reopening was coming through,” said Andreas Bruckner, European equity strategist at Bank of America. That’s been a “near-perfect combination” for European stocks to beat their US peers, he added.

Can the boom last?

Investors are divided on whether Europe’s moment in the sun can endure. Many of the region’s stocks still look like good deals, even with recent gains. Europe should also continue to benefit from the uptick in consumption in China.

“There is quite a lot of room for this to continue to play out,” Saldanha said.

Even so, what happens next in Russia’s war in Ukraine remains unpredictable. And the economic outlook for the second half of this year is uncertain.

Economists at the Fed predict the United States will fall into a “mild” recession as a result of the recent banking crisis. There are questions about whether Europe could follow.

“We think we’re now at the turning point where growth starts to weaken,” Bruckner said.

If the Fed, worried about the severity of a potential downturn, stopped raising interest rates — and even began to cut them — US growth stocks could see a resurgence, while value stocks in Europe may once again be cast aside.

And over the longer term, the large number of older, established businesses in Europe compared with exciting upstarts in the United States puts Europe at a disadvantage, Bruckner said, warning of “the old-versus-new economy divergence.”

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