European markets trade at a discount to the U.S. Does that make them attractive despite the uncertainty that plagues the European economy and the political risk associated with Brexit
and the possibility of it spreading to other countries that might vote for anti-eurozone
I believe European equities are relatively attractive compared to the U.S., but one might retort—as one of my fellow market strategists did recently during a global investing panel discussion—that European markets always trade at a discount to the U.S. What makes the discount particularly attractive today?
For starters, while we say in the U.S. that stocks look expensive on a raw price-to-earnings (P/E)
multiple basis, a proper fair value model incorporates the discount rate to value future cash flows. Historically low interest rates
in the U.S. suggest that U.S. equities are perhaps reasonably valued given the low discount rates that are central to market valuations
In Europe, the earnings multiples are even lower—and the resulting earnings yields
higher— and the bond yields are even lower than those in the United States.
For example, the U.S. earnings yield based on current-year earnings is roughly 5.4% (1/PE ratio of 18.5), while our 10-Year bond yield
is 1.56%, giving an earnings yield premium (difference of earnings yield and bond yield) of under 4%.
For Germany, this premium is nearly double that of the U.S., as the earnings yield is 7.4% and the bond yield is -0.15%. If one believes the TINA (that stands for “there is no alternative”) narrative for the income and asset allocation supports the case for equities in the U.S, then this particularly applies to European assets, especially German equities.
This is just further valuation support showing Europe sells at a greater discount.
But a second and maybe stronger point is that European sales and earnings—particularly for the exporters of Europe— are showing signs of more robust growth than earnings and sales in the U.S.
The table below shows the median sales growth and earnings growth for the S&P 500 Index
and the WisdomTree Europe Hedged Equity Index
, which focuses on multinationals from Europe with revenue diversified across the globe.
Sales and Earnings Growth of S&P 500 versus European Multinationals
Stronger Sales, Earnings Growth in Europe
The median sales growth for these European companies, year over year, was 10%, while the median sales growth in the U.S. was just 1%. And I think there is potential for this trend to continue.
In 2015, reported GAAP
U.S. earnings on the S&P 500 declined 15% on a reported earnings basis, and I believe roughly half of that decline came from the U.S. dollar’s strength (the other half was the decline in oil prices and collapse of earnings in the Energy sector).
While the U.S. dollar move was a one-time translation impact of earnings coming in at stronger U.S. dollar prices (weaker foreign translation of earnings), we have shown that it can take as long as three years before U.S. export competiveness is fully affected.
Similarly, we have seen that a weaker euro can translate into a more robust export environment after a lag. I think we are seeing benefits in this stronger sales growth and earnings growth currently, but the question remains whether European multinationals can continue to make progress, realize even greater sales and take global market share from competitors as a result of being priced more competitively at a weaker euro value. I think they could.
If the U.S. has this headwind that can continue to be a relative drag on earnings going forward and European markets have a bit of a tailwind for earnings, this could make the valuation argument even stronger and help make a case to look more positively on European equities.
Unless otherwise noted, data source is Bloomberg as of 9/28/16.