• Wealth Management

European Stocks Start to Play Catch-Up

The U.S. has outperformed Europe in recent years, but that may be changing now.

European stocks posted disappointing returns for the last half of 2017 and the first quarter of 2018, but not so far in April. This month, Europe is outperforming the U.S. and I think that dynamic could last a while longer.

One of my forecasts for 2018 has been that European markets would do better than the rest of the world.  But in Europe, headwinds from a stronger euro, inflation concerns and an apparent peak in positive economic news have caused investors to retreat. In contrast, U.S. stocks, buoyed by tax cuts, have shown strong earnings growth and mostly moved sideways, despite the increase in volatility.

Now, however, Europe’s growth is picking up and has the potential to be more impressive than what we see in the U.S., where the economic cycle is already old and the impact of tax cuts is likely to fade. Below are three reasons why I think European markets may outperform the U.S. for the rest of this year:

Europe is still at an early stage of its economic expansion. Europe’s economy remains robust, with plenty of room for business activity to increase and profit margins to climb. This is in contrast to the U.S. where the economic expansion has gone on much longer than usual and late cycle dynamics—like peak profit margins and low unemployment—are evident.

The European Central Bank is a lot more dovish than the U.S. Federal Reserve. The ECB isn’t expected to start raising interest rates until mid-2019. The U.S. has raised rates six times since late 2015 and is expected to hike at least a couple more times this year. That’s a headwind for markets.

European stocks are a lot cheaper than U.S. stocks. The MSCI Europe index is selling at 14.1 times its forward price-earnings multiple compared to about 16 times for the S&P 500 Index (generally, the higher the multiple, the more expensive the stock). The European Index’s dividend yield of 2.78% is also attractive. Investors aren’t bullish on the region, which leaves upside if investor sentiment and positioning improves. Already investors are taking note of Europe’s relative political stability, especially as trade risks recede.

Bottom line: Although my expectations for European outperformance did not play out as I expected in the first quarter, I still think that investing in the region is a good idea. Investors should consider adding some exposure to European stocks (unhedged for currency fluctuations) to their portfolio.

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