The US benchmark S&P 500 is only beating its European counterpart — the Stoxx 600— by two percentage points so far in 2019.
That may seem like strong outperformance upon first glance. But compared to how the last decade has unfolded, it’s a downright miracle the Stoxx 600 has hung in there so admirably.
Let’s zoom out a little bit more: Since the US market bottom in March 2009, Europe has underperformed the US by a whopping 76%, according to data compiled by Goldman Sachs. No matter how you slice it, it’s been an uncanny period of dominance for American equities.
Goldman says this divergence in fate boils down to one key element: corporate profits. Earnings-per-share for the S&P 500 is currently 86%, compared to just 3% for the Stoxx 600.
“EPS differential explains 100% of this underperformance,” Lilia Peytavin, a portfolio strategist at Goldman, wrote in a recent client note.
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That’s all well and good, but understanding the root cause of Europe’s underperformance won’t fix it. So what will? Maybe a further escalation of the US-China trade war? The thinking there is that Europe can skate by as two other global powers duke it out, then pick up stray investors who flee either region.
Not so fast, says Goldman.
“Realistically, in our view, Europe is unlikely to remain insulated in the event of an escalation of trade tensions between US and China,” Peytavin said. “Should tariffs be implemented across the board and include Autos, concerns would rise regarding European car exports to the US.”
However, Goldman isn’t here to be a total buzzkill. It does see four possible scenarios that could result in Stoxx 600 strength relative to the S&P 500. And if more than one happens concurrently, even better. They are as follows:
(1) Rising bond yields, growth, and inflation expectations
Goldman says this confluence of factors would support value stocks — especially banks — and possibly weigh on the future performance of higher-duration areas of the market, like tech. The firm also says this could happen to an outsize degree in Europe.
“This could occur in the Euro area, where governments could use fiscal policy to boost growth,” Peytavin said.
(2) Rising US inflation
Goldman notes that this outcome could result from a further escalation of the US-China trade war. The firm warns that it could also stem from mean reversion in the more volatile categories making up traditional inflation readings, like apparel and financial services.
“This would likely trigger a sharp repricing of the Fed’s policy,” Peytavin said.
And as the past year in US equities has shown one thing, it’s that the market’s greatest destabilizer is a sudden shift in the Fed’s outlook.
(3) Declining risks in Europe
Goldman sees this scenario having one major side effect: a decline in the European equity risk premium. That, in turn, would like result in inflows into European stocks.
“This could occur as a result of a coordinated fiscal expansion and/or business friendly measures in France and Italy, for instance,” Peytavin said. “A resolution of the Brexit impasse would also help reduce economic risks and outflows from UK equities.”
(4) A shift away from tech outperformance
At the core of this outcome is the indisputable fact that the US market features far more tech firms than Europe. And far bigger ones. That’s helped the S&P 500 outperform as the sector has soared over the past 10 years.
If tech loses its luster, that would create a mean-reversion situation that would favor the European stock market, which is less tech-exposed.