Equities: US Versus Europe
Specific factors have helped the US stock market to outperform all other stock markets since the beginning of the year.
A performance based on two pillars
The US stock market managed to perform well, gaining 5.4% since the beginning of the year. This increase was achieved despite a high valuation and net negative fund flows, unlike other main equity markets which benefited from net inflows. The good relative performance of the US stock market is based on two main factors: firstly, share buybacks (companies purchasing their own shares), and secondly, the excellent performance of a handful of internet or technology stocks. Indeed, share buybacks have accelerated since the beginning of the year thanks to mergers and acquisitions and share buyback programmes, encouraged by the US tax reform. Buybacks amounted to 2.1% of the total capitalisation of the S&P 500 index in the first half of 2018, with a large contribution from the Technology sector (40% of buybacks), followed by Financials and Health Care.
Market upside potential is limited in the US
In 2018, thanks to tax cuts contributing 7 percentage points to US corporate earnings growth, the latter is well above the global average: 22% vs. 15%. In 2019, earnings growth will converge towards the global average: 9.9% vs. 9.4%, according to consensus estimates. The positive effect of tax cuts will have decreased sharply. Share buybacks will also be much less significant. The potential upside of US equities is not constrained by earnings momentum but rather by the valuation level. This is not necessarily reflected in the price-to-earnings ratio because it has been distorted as a result of tax cuts. But the overvaluation situation becomes extremely visible when using ratios such as prices divided by cyclically adjusted price-to-earnings (CAPE, which is currently at 32, a 17-year high), the price-to-sales ratio (2.1x), or the price-to-book ratio (currently 3x).
As for the dividend yield, it has lost its attraction. At 1.9%, its level has again fallen below bond yields, even for short maturity bonds. This will encourage investors previously attracted to equity markets (in their search for yield) to return to an asset they are more familiar with, i.e. bonds. In our view, today the upside potential of US equities is not greater than other markets, but more in line with the MSCI World AC index.
Penalizing factors in Europe during the first semester.
The US market is benefitting from several drivers, but Europe seems to be making no headway. Sector-weighting plays an important role in the performance gap between the two regions. While the US is largely exposed to technology stocks (25% of the MSCI US) and the main source of growth, Europe has virtually none (6% of the MSCI Europe). The latter is differentiated by a strong rate of financials and export-related stocks (cyclicals and consumer staples). These sectors have recently borne the brunt of the challenging environment.
If we inter-change the sector weightings of the United States and Europe, how would the performance of both regions evolved? With a similar sector weighting to Europe's, the US index would not have risen by 5% year-to-date, but by only 2.2% (on July 27). Conversely, the MSCI Europe index, which has increased by only 0.7% (in euros) year-to-date, would have gained 3.7% with an identical sector structure to that of the MSCI US.
The good performance of the US market is clearly reduced when using equal-weighted indices. Europe even caught up with the US at the beginning of the year (see chart below), but political and macroeconomic worries made investors focus on solid growth, with US stocks regaining their leadership position. The European markets tumbled after the Italian crisis in mid-May that severely penalised the banking sector.
That said, we continue to believe that the second half of 2018 should be especially friendly to cyclical sectors (to which Europe is exposed) thanks to rising interest rates, dynamic economic growth and robust company fundamentals.