OPINION

Over the past few years, there have been recommendations aplenty to look to Europe instead of the United States when buying shares. The argument goes that Europe’s stock market will outperform the US in
the future because shares in Europe are a lot cheaper than those in the US.

It comes when America’s S&P 500 has delivered a 158 per cent return over the past decade (to December 31, 2023), versus the (rather minuscule in comparison) 43 per cent return delivered by the MSCI Europe stock index.

Yes, European stock markets are cheap relative to the US, but investors should look past the valuation and understand the valid reasons why. And perhaps in understanding the differences between the US and Europe stock markets, there are also lessons for New Zealand.

Looking under the bonnet

If you look beneath the hood of European equity markets, you will find an index more heavily weighted to “old economy” companies, such as financials (banks and insurance companies), industrial firms and consumer staple companies, which sell items in the middle aisles of a supermarket.

By comparison, higher-growth technology companies play a more substantial role in shaping the US market. All things being equal, technology companies generally grow profits faster. As earnings are what drive share prices, it makes sense investors will be willing to pay more for faster-growing profits. Would you rather own Nestle and Shell, or Amazon and Alphabet? This goes part of the way to explaining why shares in US companies are more expensive than in European ones.

Burdensome regulation can stifle growth

Increased regulatory burden has hampered Europe’s competitive position, hindered innovation and is particularly challenging for small and medium-sized companies. The root cause is hard to identify. There are, of course, cultural differences between Europe and the US, but Europe also has more complexity with regulation, from both individual countries and the single market.

The formation and growth of Silicon Valley firms through the 2000s to the boom we are seeing from AI firms today is evidence that the US has created an environment that fosters innovation. While countless hours are being spent by software engineers in the US trying to outcompete each other for the next AI breakthrough, European lawmakers are apparently burning the midnight oil to prepare the first AI Act!

Lack of economic diversification is hampering growth

The Ukraine war continues to have an impact. Europe (mainly Germany) is one of the largest exporters of manufactured goods globally. For years before the war, cheap Russian natural gas flowed to Europe and was its main energy resource driving the industrial complex. Arguably, parts of Europe became too reliant on Russian gas. Now that supply has been significantly reduced, European companies are looking to relocate abroad where they can lower production costs. This hampers European economic growth. It is also in stark contrast to the US, where companies are being offered subsidies and/or tax breaks through the Inflation Reduction Act to reshore their operations to North America.

China is also having a two-pronged effect on Europe. China is one of Europe’s largest trading partners, but its economy is slowing down. However, China is expanding its influence in the global electric vehicle (EV) market – threatening an industry that’s been an economic force for Europe for decades.

According to a report by the International Energy Agency, China was responsible for 35 per cent of global EV exports in 2022. In fact, Chinese carmaker BYD sold more electric vehicles than all European car manufacturers combined in the first half of 2023 – as did Tesla. Foreign competitors are beating Europe at its own game.

Comparing the relative successes of the US and Europe helps illustrate the foundations needed for innovation, economic growth and vibrant capital markets. For New Zealand, Europe highlights the importance of pushing towards a diversified economy, in terms of both industry exposure and trading partners. We also need to maintain policy settings that support innovation and create an environment for businesses to thrive.

– Harry Smith is a Portfolio Manager at Fisher Funds