European Equities: A Risky Investment Choice?

European equities have historically been less attractive to investors than their US counterparts, but are they a bad investment? In this article, we will explore the factors that have influenced the performance of European equities and evaluate their potential for growth. We will also discuss the role of private equity and the impact of economic conditions on investment opportunities. Finally, we will analyse the outlook for the continent's equity market and assess whether European equities are a wise choice for investors.

Poor performance of European equities relative to the US

European equities have historically underperformed when compared to the US market. This is due to a variety of factors, including sluggish economic and earnings growth, political volatility, and weak demand and macro uncertainty, which have created a severe lack of confidence in the market.

One of the key reasons for the underperformance of European equities is the lower profitability of European companies compared to their US counterparts. US companies have higher operating profit margins, with a rate of 13% compared to just 10% for the European Stoxx 600 or the Eurostoxx 50. This is due in part to the higher weighting of sectors with structurally higher profit margins in the US, such as technology and communications, which account for about 20% of the US stock market. In contrast, the financial sector in Europe, which has been under pressure for years, makes up about 20% of the market. As a result, corporate earnings in the US have risen much more strongly than in Europe, with the reported earnings of the S&P 500 rising by 400% since 2002, compared to just 230% in Europe.

The composition of the European market also differs significantly from that of the US. Technology stocks, for example, make up around 30% of the US market but only about 7% of the European market. This has contributed to the European market's inability to keep pace with the US, particularly during the recent boom in growth stocks powered by a surge in demand for AI.

Additionally, European stocks have historically been slower to rebound from crises than those in the US. For example, the DJ Eurostoxx 50 equity index has never returned to its peak in 2000 or its slightly lower peak in 2007, unlike the innovation-driven highs of the S&P 500 in the US, which has set record after record in recent years.

However, it is important to note that the performance of European equities relative to the US has improved in recent years. While they still lag behind in long-term comparisons, European equities have made up some ground. For instance, the European Stoxx 600 index has risen by about 250% since 2002, compared to a rise of around 390% for the US S&P 500 index.

Looking ahead, there are reasons to be optimistic about the potential for European equities to narrow the gap with their US counterparts. Lower oil prices, a more positive economic outlook, and the resolution of political issues could all contribute to improved performance. Additionally, the undervaluation of European companies compared to US companies may present an attractive entry point for investors seeking exposure to the equity market outside of the US.

Political volatility and economic uncertainty in Europe

Furthermore, Europe's manufacturing-heavy economies, such as Germany, have suffered due to global manufacturing doldrums. Households accumulated too much "stuff" during the pandemic and shifted their spending to services once the reopening began, hurting Europe's manufacturing-intensive industries.

Compounding these issues, Europe has also faced an energy price shock, reduced export demand due to a Chinese slowdown, weak labour productivity, and rising interest rates. These factors have contributed to sluggish economic and earnings growth, creating a severe lack of confidence among investors.

However, there are signs that the situation may be improving. Europe has successfully pivoted its energy supply from Russian pipeline gas to LNG, and a relatively mild winter has led to a quick decline in gas prices and headline inflation. Falling energy costs will benefit both household finances and the manufacturing sector.

Additionally, there is a potential for consumption to rebound, as household spending is expected to be supported by positive real wage growth and elevated pandemic-related savings. The European Central Bank's (ECB) rate-cutting cycle is also anticipated to begin earlier than that of the US Federal Reserve, which could further boost the economic and corporate outlook.

While political volatility and economic uncertainty have posed challenges for European equities, the continent is showing signs of recovery and resilience.

Energy price shocks and reduced export demand

The impact of elevated energy prices on export performance is twofold. Firstly, higher energy prices tend to dampen global demand as income is redistributed from energy-consuming countries to energy-producing ones, who typically have a lower marginal propensity to spend. Secondly, energy costs are a critical component of production costs, and higher prices can undermine the competitiveness of European exporters in global markets.

The euro area, in particular, has been disproportionately affected by the energy supply shock. Wholesale gas prices in the euro area were, on average, 13 times higher in 2022 compared to 2020, while the United States and Asia experienced increases of 3.5 and 9 times respectively. This has negatively impacted the price competitiveness of euro area exporters, especially in energy-intensive sectors such as basic metals and chemicals, which saw significant contractions in exports.

The energy price shock has also contributed to a decline in export growth in the euro area. While empirical evidence suggests that shifts in global demand conditions and supply bottlenecks have been the primary drivers, the energy supply shock has played a role in lowering export growth by about 0.6 to 0.8 percentage points on average over the past year.

Looking ahead, the medium-term outlook for competitiveness in the euro area remains uncertain. Despite a fall in energy prices since the summer of 2022, they remain elevated compared to pre-pandemic levels. Additionally, the euro area faces significant challenges in securing alternative sources of energy to replace Russian gas supplies over the medium term, which could result in structurally higher prices and more volatile import prices.

In summary, energy price shocks and reduced export demand have had a detrimental effect on European equity markets. The surge in energy prices following the Russian invasion of Ukraine has led to decreased economic activity, higher production costs, and reduced export competitiveness, particularly for energy-intensive industries. These factors have contributed to a decline in export growth and negatively impacted European equities. While there has been a subsequent fall in energy prices, the medium-term outlook suggests that energy prices will remain elevated, continuing to impact European export performance and equity valuations.

Lack of investor confidence in Europe

Europe has long been considered a less attractive prospect for investors than the US, and this has resulted in a lack of confidence in the region's equities. This is reflected in the performance of the STOXX Europe 600 Index, which has consistently underperformed the S&P 500. Several factors have contributed to this historical underperformance, including sluggish economic and earnings growth, political volatility, weak demand, and macro uncertainty. These factors have created a severe lack of confidence among investors, leading to a discount in European stocks' comparative valuation.

One of the main reasons for the lack of investor confidence in Europe is the region's economic performance. Europe has faced stagnant growth, largely due to the ripple effects of Russia's invasion of Ukraine and the resulting energy crisis. The loss of its main supplier of natural gas caused a colossal shock to Europe, with spiralling bills impacting households and businesses. This led to a cost-of-living crisis that was more painful and prolonged than in other regions. Additionally, Europe's manufacturing-heavy economies suffered due to a global shift in consumer spending from goods to services following the pandemic.

Another factor contributing to the lack of investor confidence in Europe is the region's fiscal and monetary policies. Delays in deploying the €750bn recovery fund and the impact of short-term commercial bank financing have further damaged Europe's economic outlook. In contrast, the US has seen significant growth driven by government spending, with the budget deficit running at 6% of gross domestic product. Europe's monetary policy has also been less effective than that of the US, with the European Central Bank (ECB) facing challenges in taming services inflation and wage pressures.

The performance of European equities has also been impacted by the energy price shock and reduced export demand due to a Chinese slowdown, as well as weak labour productivity and rising interest rates. However, there are signs that the economic activity has bottomed out, and momentum is expected to build in the coming quarters. Falling energy costs and positive real wage growth are expected to benefit household finances and support consumption, which could lead to a rebound in the European equity market.

Despite these challenges, there are some positive signs for European equities. The region has made significant progress in pivoting its energy supply from Russian pipeline gas to LNG, and a mild winter has helped to quickly reduce gas prices and headline inflation. Additionally, the ECB's potential early start to the rate-cutting cycle could support both the economic and corporate outlook. However, muted earnings growth expectations compared to other major developed markets continue to limit the strength of investor confidence in the region.

Europe's declining working-age population

By 2040, the working population of the four largest Euro area countries—Germany, France, Italy, and Spain—is projected to decline by 6.4%. This decline will have a direct impact on economic output, as a smaller working-age population translates to reduced production capacity. It is estimated that this could lead to a 4% decline in potential output for these economies over the period from 2000 to 2040, amounting to an annual decrease in growth potential of around 25 basis points.

The ageing population also has significant implications for labour shortages, lower potential growth, higher healthcare costs, and pressure on pension systems. Europe's declining working-age population is expected to result in a more chronic issue of labour shortages in the eurozone job market, constraining the growth potential of the region's economy. Additionally, the increasing number of retired individuals will place a higher burden on the working-age population in terms of providing for their needs.

To address these challenges, policymakers have considered various options, including encouraging higher birth rates, increasing net migration, improving participation rates among domestic labour markets, and raising the retirement age. However, despite decades of implementing policies aimed at boosting birth rates, these measures have not had a significant impact. As a result, attention has shifted to other strategies, such as migration and improving labour force participation.

The impact of Europe's declining working-age population is expected to be felt across various sectors, particularly those that are labour-intensive, such as hospitality, construction, and business services. Companies in these sectors are already adjusting their business models, adopting new technologies like robotics and software automation, and exploring initiatives related to recruitment and technology adoption to navigate the reduced labour availability and higher costs.

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