Capital Economics: US Stocks to Outperform Europe Until AI Bubble Burst - When Will the Big "Pop" Happen?

 

US stocks have outperformed European ones since inflation made a strong comeback after a decade of price pressures. Capital Economics explores the reasons behind this trend and its implications for European stock market prospects. It concludes that American stocks will gain a clearer edge over the next year, but only if the AI bubble bursts, which is expected to happen, but not just yet.

1. The Resilience of European Stocks

Much has been said about the strong performance of US stocks, not just this year, but generally over the past fifteen years. However, it's worth noting that stocks in the rest of the developed world, particularly in Europe, have held up quite well against US stocks over the past two years, according to Capital Economics.

Admittedly, the immediate recovery after the pandemic was much stronger in the US than in Europe. This was largely due to the significant rebound in US technology stocks, which were driven higher by the belief that the global economy would increasingly depend on technology, as the pandemic had demonstrated how physical interactions could be replaced by digital ones.

Since late 2021, however, European stocks have performed almost as well as US stocks. At the beginning of 2022, stock markets sharply declined as inflation and yields on "safe" assets rose, causing MSCI indices for the US and Europe to experience similar declines. However, when investors were reassured that inflation would return to target with minimal economic pain, stock markets recovered. Since then, stocks in Europe and the US have generally shown similar performance—at least until very recently.

This, as Capital Economics points out, might be surprising. After all, the main story in recent stock markets has been the growing excitement about artificial intelligence, which has primarily benefited the US stock market since most of the "big tech" companies are listed there. Additionally, both the euro and the pound have weakened slightly against the US dollar, further trimming returns. While the Swiss franc has been somewhat stronger, Swiss stocks represent only about 15% of the MSCI Europe Index. Thus, valuations have risen faster in the US, and foreign exchange has acted as a headwind for European stock returns in common currency terms, notes the firm.

However, until recently, this was offset by the fact that expectations for company earnings in Europe were rising more sharply than in the US, and by higher dividend payouts from European companies. The positive contribution from earnings expectations occurred mainly between 2022 and early 2023. This was due to better earnings retention in Europe compared to the US, where recession fears had a greater impact. As for dividends, US companies usually prefer stock buybacks. Moreover, there are undeniably more investment opportunities in the US, limiting the room for companies there to pay dividends.

2. Drivers of European Stock Performance

By country, the main contributors to the rise in the pan-European stock index—and thus to European stock returns competing with US stocks—have been the UK, Denmark, Spain, and Italy, notes Capital Economics.

Sector-wise, stocks in banking, healthcare, energy, and industrials have led the way, with the strong performance of the first two nearly offsetting the performance of the tech sector in the US.

One key reason UK stocks boosted the European index and had slightly higher returns compared to US stocks is that they did not fall as much as stocks in other countries in 2022. This may reflect both their low valuations at the outset and a greater weight in "defensive" sectors. In reality, UK stocks did not perform exceptionally well, but since they represent nearly a quarter of the European index, their contribution was significant.

Additionally, the large contribution of Danish stocks relative to their size in the index (less than 6%) primarily reflects the strong performance of a pharmaceutical company, Novo Nordisk, the world's largest seller of weight loss drugs.

Financial sector stocks are responsible for almost all the gains in the total return indices for Italy and Spain. Not only do they represent about 40% of each index, but they have performed particularly well since the stock markets hit their lows in 2022. This likely reflects the improved economic environment—to which banks are particularly exposed—and the prospects for stabilization of interest rates at higher levels than before 2020, which would mean less pressure on banks' interest margins.

Admittedly, these factors are also present in the US, notes Capital Economics. However, the financial sector represents a much smaller share of the US index. And, unlike in the US, the valuations of Italian and Spanish stocks never rebounded after the Global Financial Crisis and the eurozone sovereign debt crisis, leaving much more room for recovery.

Meanwhile, French stocks have declined in recent months, causing the European index to underperform the US index. Between the end of 2021 and June 2024, stocks in France had slightly higher returns than those in the US. However, French President Emmanuel Macron's decision to call early parliamentary elections triggered a correction in French assets, including stocks. Given the weight of French stocks (~17%), this was enough to cause the European index to lose ground to the US. This explains the widening gap between the two indices since June, according to Capital Economics.

3. Prospects for European Stocks

A) Short-term Prospects are Better in the US

Capital Economics believes that US stocks will outperform European ones for a while longer. The recent correction in the US stock market has now been "covered" for the most part, and artificial intelligence will continue to drive stocks higher over the next 12 months. The firm estimates that the bubble in the US will continue to inflate, disproportionately benefiting the US stock market. Indeed, despite the analysis above, enthusiasm for artificial intelligence seems to have already pushed US stocks higher compared to other markets, and it has been the dominant factor in the market. While markets had similar performance since the end of 2021, the US market performed better than Europe since March 2023, when concerns about a potential banking crisis in the US subsided and a few months after ChatGPT was released. This period is expected to set the tone for the next year or so, according to the firm.

"The result is that we expect US stocks to outperform those in Europe, as well as the rest of the world, until the end of 2025," emphasizes Capital Economics.

B) However, European Prospects Are Still Strong

The firm remains quite optimistic about the prospects for European stocks in absolute terms. Essentially, it estimates that enthusiasm for artificial intelligence will boost not only companies directly involved in technology but also the broader corporate sector. This is because artificial intelligence is a general-purpose technology that will ultimately have a positive impact on most sectors of the economy.

It is worth noting that, unlike the last phase of the dot-com bubble, Capital Economics doubts that any expansion of the artificial intelligence bubble will mean that European stocks will begin to outperform US stocks and catch up with them. This is mainly because, unlike then, Europe does not have the technological "champions" that would make this possible.

Furthermore, low valuations of European stocks and modest expectations for earnings growth in the region cause caution, as noted. Despite the recovery of European stocks since late 2022, their valuations are still around historical norms and therefore not as "stretched" as those in the US.

Specifically, the valuation of French stocks could rise further and reduce at least part of the gap with other markets. Although political uncertainty will continue to put pressure on bonds, the French stock market is undoubtedly less vulnerable, given that most listed companies are multinational and operate worldwide.

Meanwhile, there is still room, according to the firm, for a rise in banking stocks in the region, particularly in Italy and Spain. Despite the recent rally, their valuations still remain close to their lower levels.

However, Capital Economics is less optimistic about the UK, despite seemingly low valuations. This is due to the fact that, when considering different sector compositions, the valuation gap with US stocks is not far from where it was on average between the Brexit vote and the pandemic.

Finally, analyst expectations for long-term earnings per share (EPS) growth also appear much more cautious in Europe than in the US. IBES estimates show that long-term earnings growth expectations in Europe are close to the historical average but significantly above the average in the US. Indeed, in the US, they are nearly as high as they were at the peak of the dot-com bubble. Thus, there appears to be more room for earnings to exceed expectations in Europe than in the US.