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Europe records its biggest outperformance on record versus the US

After years in the wilderness, European stocks are finally getting their act together, just when the US Big Tech keeps drifting lower and lower.

European stocks have recorded their biggest outperformance on record versus the US in the fourth quarter — a mind-blowing 13% in US dollar terms and 11.7% in euro terms (see the chart). And the beat is extending to the new year. Since the end of September, the Stoxx 600 is up 17% in euro compared with the S&P 500’s 2.8% loss.


Institutional investors are starting to notice. Some of them raised their rating on European stocks, saying valuations already discount a 15% drop in earnings. Despite their rally, European stocks continue to screen as inexpensive versus US counterparts. The S&P 500’s forward price-to-earnings (P/E) ratio of about 17.2 is still far more (37%) than the Stoxx 600’s 12.5 times, at the upper end of a 17-year range and about double the 20% average premium for the period (see the chart). The Stoxx 600's P/E ratio suggests investors continue to expect a European Central bank (ECB) to stop hiking in the second part of the year, as well as a resilient earnings growth for this year. As Euro-Area inflation returned to single digits in December (9.2%, versus 10.1% in November) for the first time since August, fueling hopes that the bloc’s worst-ever spike in consumer prices has peaked, the ECB could decide by mid-year to stop its most aggressive bout of interest-rate hikes in its history.

It is not all about valuation. Europe is also benefiting from plummeting volatility brought on by tailwinds such as a weakening dollar and signs of reopening and stimulus in China, and from falling gas and power prices to pre-war levels. Mild weather in recent weeks has helped to curb demand for both power and gas, helping to reduce prices as Europe seeks to escape winter without severe shortages. Further support comes from France, which is ramping up the availability of its state-owned fleet of nuclear reactors after months of extended outages, in a sign of relief for Europe as it battles a historic energy crisis. The availability of Electricité de France’s 56 reactors hit 73%. That is the highest since February and a strong increase from lows around 40% in August! The return of the units gives the region another means to fight the energy supply crunch amid lower natural gas flows from Russia.  

At the same time, the US is suffering from what has been driving its continued outperformance over the past decade: its heavy skew towards megacap tech. In fact, stripped of Tesla, Amazon, Apple, Alphabet, Microsoft and Meta, the S&P 500 has performed much in line with the Stoxx 600 since the end of the third quarter, in local currency terms, while the Dow Jones Industrial index is even beating the European benchmark. Being loaded with strongly performing value stocks has been a clear boon for Europe in the past year and that trend has further to go. At the same time, mega-cap technology risk to see further margin pressure, and a negative impact from commodity prices and real interest rates.

Earnings also favor Europe. While estimates for the region’s firms have stopped outpacing their US counterparts over the past few months, there remains a wide gap with relative prices that’s only recently started to close. The European stock market can decouple from falling earnings later in the year, as inflation peaks and central banks stop hiking.

To be sure, not everyone is convinced about the longevity of Europe’s rally. Some observers consider the region has benefited from a drop in risk aversion and still faces persistently high core inflation (5%) and a composite PMI index in economic contraction territory (48.8). They warn that if core inflation remains elevated in the Euro-Area for all of 2023 and the ECB holds the rate at 3.5% (pushing the European economy deeper into recession), the index's forward multiple could retest last September's lows of about 10x.