David Joy: European Stocks Outperforming U.S.

Despite a widely held, although by no means universal, view that U.S. equities would outperform their European counterparts this year, that has so far not been the case. Since the start of the year, the Stoxx Europe 600 index is higher by 3.1%, and resides at a six-year high, while the S&P 500 is lower by 0.2%.

Nor is the disparity related to currency movements, as the euro is little changed versus the dollar. While U.S. stocks are struggling with the impact of weather on economic performance, and the implications of Fed tapering, Europe appears to be benefiting from evidence of ongoing economic improvement.

The latest forecast from the European Commission anticipates economic growth of 1.2% this year in the Eurozone. Although that level of growth is relatively modest, it represents a dramatic improvement over the 0.4% decline in 2013.

The forecast is not without significant risk, of course, as the continent struggles to recover from the financial crisis. Growth throughout the Eurozone remains uneven, debt levels are high, unemployment hovers near 12%, and inflation is dangerously below 1%. Nevertheless, progress is being made, and equity prices reflect that. In the U.K., where the FTSE 100 is higher by 1.2% in local currency terms, growth is expected to accelerate to a rate of 2.9% from 1.9% in 2013.

Although European equities still enjoy a relative valuation advantage, just as with stocks in the U.S., they are no longer as cheap as they used to be. According to Bloomberg, the forward P/E multiple on the Stoxx 600 is now 14.5x, whereas one year ago it was 12.5x. For the FTSE, it is now 13.9x versus 11.6x. By comparison, the forward P/E on the S&P 500 is currently 15.7x versus 13.5x one year ago.

One important hurdle facing the Eurozone in its path to full recovery is the current review of the health of the banking sector being conducted by the European Central Bank. The two-part review includes an assessment of the quality of assets on the books, and the adequacy of bank balance sheets to withstand a severe economic downturn, much as has been undertaken in the U.S. This is a first for the ECB and a rigorous review can be expected, given the credibility risk to the central bank if the review is seen as anything less.

Since the results will not be known for some time, there is some lingering concern over whether sufficient equity will be available to banks that are found to be deficient, either from the capital markets or sovereign injections. The review is not expected to reveal significant deficiencies, but suspicions will remain until the results are known. If the report card, by and large, reveals a clean bill of health, it will contribute to the ongoing recovery in confidence in the region, and lead to increased lending activity. At least that is the hope.

The recovery remains fragile, and therefore susceptible to an adverse shock. Theoretically, at least, the ECB has additional tools at its disposal to provide additional monetary stimulus if necessary. However, whether it truly has the flexibility to launch a Federal Reserve-type quantitative easing program remains an open question. The German Constitutional Court recently ruled that the ECB's "Outright Monetary Transactions,” or OMT program, which allows it to buy Eurozone sovereign bonds in unlimited amounts under certain circumstances, violates European Union law. It left a final decision up to the European Court of Justice.

Ultimately, the ongoing recovery in Europe is occurring as the Eurozone continues to experience growing pains, making the appropriate policy responses more difficult to identify and enact. The good news is that the recovery is solidifying. There is a lot more work to do, but progress is being made.

Disclosure

The views expressed are as of the date given, may change as market or other conditions change, and may differ from views expressed by other Ameriprise Financial associates or affiliates. Actual investments or investment decisions made by Ameriprise Financial and its affiliates, whether for its own account or on behalf of clients, will not necessarily reflect the views expressed. This information is not intended to provide investment advice and does not account for individual investor circumstances. Investment decisions should always be made based on an investor's specific financial needs, objectives, goals, time horizon, and risk tolerance.

The STOXX Europe 600 Index is derived from the STOXX Europe Total Market Index (TMI) and is a subset of the STOXX Global 1800 Index. With a fixed number of 600 components, the STOXX Europe 600 Index represents large, mid and small capitalisation companies across 18 countries of the European region.

The S&P 500 is an index containing the stocks of 500 large-cap corporations, most of which are American. The index is the most notable of the many indices owned and maintained by Standard & Poor's, a division of McGraw-Hill.

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