The US stock markets have long been a favourite of investors who have been attracted by hefty returns. Another factor boosting investor interest has been the strengthening US dollar. But something new is happening right now. In recent weeks, there has been a growing interest in Europe and the euro has strengthened against the dollar. Is it Europe’s turn now?
The weakness of technology stocks
Over the past few years, the US stock markets have been boosted by a strong rise in technology stocks. US companies enjoy a strong position in the technology market thanks to robust innovation, capital markets, venture capital markets and management culture. At the same time, technology stocks have also benefited from the digitalisation boom and low interest rates, which raise the present value of future expectations.
Now many technology companies see their stock prices plummeting. The ‘dull’ blue chip stocks are making a comeback. There is no lack of these dull shares in Europe, which therefore benefit from the waning interest in technology.
US dominance
The United States has been making up a gradually increasing percentage of the world equity index, the current figure being around 60%. Few European investors have been willing to increase their weighting that high. Even the Norwegian State Pension Fund has set the US weighting at just 45%. While investors’ allocation decisions to increase US weightings have been lagging behind, they have nevertheless risen.
Low-priced European stocks
Traditionally, European stocks have traded at lower prices than US ones. Depending on the indicators used for measurement, the difference has typically been as high as 20% in favour of the US. There are a number of explanations for this. The US capital markets are liquid and US companies are well managed. Corporate growth, return on equity, and profit margins have remained at a sound level. Ultimately, it is financial performance and profits that determine stock prices.
Growth in Europe lagging behind
Since the financial crisis of 2008, Europe has been lagging behind the United States in economic growth. GDP growth has been more robust in the US than in Europe, resulting in corporate profits also increasing faster. After the crisis, the banking sector also recovered more quickly in the United States.
Several indicators show that the US is outperforming Europe in economic terms. Can this change? GDP forecasts seem to suggest that growth will be faster in the United States.
Difference explained by debt-driven economy
Currently, sovereign debt in the euro area represents 95% of GDP, whereas in 2007 it was still 66%. It is a huge amount of money to sustain economic growth. However, the US national debt has increased at an even higher rate. Before the financial crisis, the US government debt was 62% but has since then more than doubled to over 120%. The increase in public debt goes a long way to explain the performance gap between countries. Now political decision makers in the United States are going to argue during this spring about the debt ceiling and how it is to be changed to allow for even more government debt financing.
Change in the US/euro exchange rate
Recently, I went on a trip to the United States as a tourist. I found it difficult to get used to the practice of adding taxes and service charges to list prices. Of course, it is mostly a matter of habit. However, the final price of a purchase gives an indication of whether or not the country is expensive. Partly, the price levels are explained by exchange rates.
Traditionally, the Economist newspaper's Big Mac index has been a handy tool for determining the "real" exchange rate. According to the current Big Mac index, the US dollar appears slightly overvalued at its current exchange rate. The euro has been strengthening for a couple of weeks now. From a grassroots point of view, the euro could easily appreciate against the dollar from its current rate of 1.10.
Purchasing power is not the only factor contributing to the appreciation of the euro. We continue to receive signals of an ever-tightening monetary policy in Europe, while the European interest rates offer a potential further incentive. A fall in interest rates is anticipated sooner in the United States than in Europe.
In conclusion
There is a growing interest in Europe among investors. One of the drivers is the cheap currency when the dollar achieved parity with the euro. This was too much and the market is readjusting the exchange rate to its long-term average and purchasing power parity. Hence, investor interest in Europe is partly due to the low-priced currency. In this respect, this interest does not rest on a sustainable basis and may well be temporary. Rebuilding war-damaged Ukraine in due course would give Europe a much-needed boost. But Europe should not copy the US debt-financed model to close the gap in economic performance. Fashioning a new industrial policy for Europe is a sounder step in the right direction.
The writer is VER's CEO Timo Löyttyniemi.
