Over the past 12 months, Eurozone equity markets have underperformed US stocks by around 11 per cent in local currency - or nine per cent in dollar terms.
There are a number of different reasons for this - but could the equity markets be about to catch up?
Slow and steady
European hard data suggest that the domestic economy is holding up well in 2016. GDP growth surprised in the first quarter, closing the gap with US growth to the narrowest since 2011.
The Eurozone continues to enjoy the tailwinds of low oil prices, accommodative monetary policy, and diminishing fiscal drag, which have supported a rise in real gross disposable income and a rebound in consumption. But these positives are partly offset by weak global trade growth, the persistence of large debt burdens, and policy uncertainties which are dampening investment recovery.
Political uncertainties linger
Looking ahead, the Eurozone is facing a busy political agenda in 2016-2017 (Spanish political gridlock, Greece’s programme, Italian institutional change, French and German elections), which is keeping the policy outlook uncertain.
Individually, each of these risks may not be sufficient to cause significant market stress. However, the Eurozone remains fragile to external shocks such as a Chinese hard landing, and we are concerned that the next economic downturn could inflame the political risks.
In addition, the uncertainty surrounding the outcome of UK referendum will persist until 23 June, as opinion polls suggest the result will be close.
As several political developments are taking place around the same time period in June this year, this could lead to higher market volatility in the summer, but it should also result in the lifting of some uncertainties in the second half of the year.
Waiting for earnings recovery
European equity valuations are more attractive than those in the US, trading at a 15 per cent discount on 12-month forward earnings basis.
If the economy keeps improving and interest rates remain at low levels, Eurozone corporates, which have lower debt than US companies, could take the opportunity to optimise their financial structures and return more cash to their shareholders. However, in the near-term we don’t expect a strong increase in share buybacks, to the extent seen in the US.
In addition, the European Central Bank is likely to keep an accommodative stance while the US Federal Reserve has reaffirmed its willingness to keep normalising its policy, potentially hiking rates again in the second half of the year. This could push down the value of the euro against the US dollar, supporting Eurozone earnings.
But, with earnings and sales growth still weak in the first quarter, we need to see a stronger recovery in companies’ results before Eurozone equities to catch up.