To The Moon

Despite the rise in the price of European stocks this year, the discount of European stocks to U.S. stocks has reached 40 percent. Now a discount of about 20 percent has been common over the past 20 years. The main reason for such a discount is the sector breakdown. Compared to the United States, there are relatively few technology companies here, and it is precisely those companies that are currently highly valued. The American technology sector is ten times larger than the European one. But even adjusted for this sector distribution, it is true that each European sector has a lower valuation than its American counterpart.

For many investors, such a discount provides a reason to consider European stocks. Still, it is wise to first take a closer look at what causes this discount. As so often, it is a complex of factors:

1. Europe was hit harder than the United States in the Great Financial Crisis. The European financial sector was much larger than that in the US, and the main export product of the US at the beginning of this century was bad mortgage loans. This even caused a euro crisis in 2012.

2. The euro itself is still a divergent system. The differences between North and South are widening, not narrowing. Rising debt as a percentage of GDP in various countries combined with rising interest rates threatens a new euro crisis in time.

3. A war on the European continent is not exactly increasing value. This war has also ensured that nowhere in the world is energy as expensive as in Europe. Europe's competitive position has deteriorated as a result. Moreover, Russians and, in its wake, Chinese and Arabs will be reluctant to invest in Europe.

4. The energy transition will cost about 5 trillion euros by 2030. About 1.6 trillion of that will come from the EU. The rest must come from national governments and the private sector. That 3.4 trillion is equivalent to 2.7 percent of eurozone GDP. Such investments depress growth in the short run, even if they make a positive contribution in the long run.

5. The U.K. is an important part of Europe and U.K. equities are at a discount to European ones, partly due to Brexit, but also due to inflation dynamics and the impact on U.K. public finances.

6. The European stock market is much smaller than the U.S. stock market. Moreover, it also consists of numerous smaller national markets, and this comes at the expense of liquidity. Europeans also put more money into houses than stocks, compared to the United States. Institutional investors in Europe also invest less in stocks than their U.S. counterparts. The lack of a European equity culture and less liquidity translates into lower valuations.

7. The U.S. stock market has benefited more from low-interest rates than the European one, in part because of the higher percentage of growth stocks. That could change now that interest rates have risen more in the U.S. than in Europe. Only, inflation seems more persistent in Europe than in the U.S., partly due to the flexibility of the U.S. economy. Where the U.S. can suffice with a soft landing, a recession may still be required in Europe.

8. U.S. companies pay less tax than European ones. The additional levies that integrated oil companies faced due to the sharp rise in energy prices also depressed valuations in Europe. Moreover, the fiscal-legal basis for such levies is wafer-thin, but it may happen more often in the future, including for other companies. In the US, such a thing is unthinkable.

9. The European economy is much more of an open economy than the U.S. economy. This also means that the boycott of Russia has more impact in Europe than in the US. Also, Europe is much more sensitive to developments in China. This component could also argue in favour of Europe if investors plunge into China en masse, but that does not seem to be an issue for a while.

10. U.S. companies have higher profit margins and perform much better than European companies. Of course, there is always a debate about whether these high-profit margins are sustainable in the future, but highly profitable companies are simply valued higher.

This listing does not mean that European investments are completely out of the question. The advantage of such a discount is that more merger and acquisition activity may be expected in Europe, given the valuation difference between U.S. companies and their European counterparts. Furthermore, of course, for U.S. stocks, past returns are also not normative for the future. At the same time, while valuation is an important determinant of long-term returns, short-term valuation (and it can safely last several years) has remarkably little impact on returns.