The Ryder Cup, the biennial golfing competition, starts this weekend. With teams from Europe and the United States set to battle it out, this is a good time to assess the relative investment case for US equities versus European equities. While both regions face political upheaval and economic challenges, relative valuations and the prospect of divergent monetary policies might give European equities an edge.
Problems facing the US and Europe
The most contentious US election in recent history is pitting two candidates that polarise opinion against each other. With the first of three TV debates over, the election is sure to take increased prominence in driving daily market moves as Election Day approaches.
Indeed Hillary Clinton’s perceived win in the debate is believed to have spurred a rally in the Mexican peso – as Donald Trump advocates aggressive policies to stem the flow of people and goods across America's southern border – and a softening of defensive assets such as gold. Yet with several weeks to go and some polls suggesting a neck and neck race, the outcome looks too close to call.
While a Trump win would likely spook the markets – emerging markets in particular, given his advocacy of high tariffs – whichever candidate wins could face resistance from Congress to their policies. The election has exposed deep fault lines in American society that neither candidate seems positioned to heal.
But Europe also faces political headwinds as it reels from the challenge that Brexit poses to its future and widespread dissent towards the EU, which has been fuelled by the migration crisis. While US politics is taking centre stage now, next year's elections in France and Germany will be major tests for incumbent leaders.
Monetary policy diverges
Irrespective of the outcome of the US elections, there are continued signs that the US Federal Reserve (Fed) is readying to raise rates again before the end of the year. It has been itching to do so for months. Such a move would mark a greater divergence in monetary policy between the US and Europe, as the European Central Bank (ECB) has implemented negative interest rates and continues to buy vast amounts of bonds to keep borrowing costs down. Expectations are building that the ECB may even step up actions as it struggles to kick start growth.
On past form, investment in these two regions paints a very decisive picture. America's S&P 500 Index delivered a total return of 121.54% over the five years to the end of August, while European equities have lagged far behind with a 74.51% return from the Europe ex UK Index. Yet it is important to remember that this was a period when the US market benefitted from vast stimulus programmes provided by the Fed that let companies borrow money cheaply and use it to buy back their own shares. We should expect to see borrowing costs rise over the coming years, so the monetary policy outlook from here is probably going to be more favourable for European equities.
The underlying growth outlook for both regions is hardly compelling. US corporate profits have peaked and the dividend outlook in Europe is very uncertain. In such an environment it is important not to overpay for assets unless you are really convinced that the earnings of a particular business are so resilient they can buck the economic trend.
From a valuation perspective, European equities have the edge, though are far from ‘cheap’. While the US market is trading on a cyclically adjusted price earnings multiple of almost 25 times earnings – considerably above its long-term median – developed market European shares are just below 15 times but this is flattered by the fact that UK shares are on a cyclically adjusted price earnings multiple of 13.7 times.
The varying fortunes of fund managers
What’s startling however is the markedly different fortunes of fund managers in these two regions. Over the last five years managers of US equity funds have struggled to keep up with a bull market in US shares lifted on a tide of cheap money. Staggeringly just five funds in the IA North American sector – little more than 6% of the universe – beat the S&P 500 Index after costs over this period. No wonder, then, that many investors have given up entirely on active funds for their US exposure, choosing low-cost trackers instead.
However, in the Europe ex UK sector it is a different picture altogether, with 65.8% of funds beating the FTSE Word Europe ex UK Index over this period, and a similarly convincing picture also appears in the UK's All Companies sector too.
In summary, both sides of the Atlantic face the potential for political shocks. The underlying growth outlook is weak, valuations are rich and it's hard to be bullish from here about either region. Investors need to be very careful however about extrapolating the stellar returns from US equities of recent years into the future – especially at a time when monetary policy is expected to diverge further between the US and Europe, and the degree of support to US equities from ultra-accommodative money policy abates. In terms of the monetary policy backdrop and valuations, European equities have the slight edge, but above all it is important to tread with care. In uncertain times we expect active managers to have greater potential to outperform.
These funds are all available via our Investment Selector. If you would like any further information, please call 020 7189 2400, request a call back or email email@example.com and someone will be in touch.
PowerShares FTSE RAFI 1000 ETF: an exchange-traded fund that holds the 1,000 largest US stocks but weights exposure according to a combination of cash flow, sales, dividends and net assets. This provides a more defensive profile than a traditional tracker. Annual costs are 0.39%
Dodge & Cox Worldwide US Stock: this is an actively managed fund run from San Francisco with a defensive, value bias. Annual costs 0.70%
Vanguard S&P 500 UCITS ETF: an exchange-traded fund that follows a traditional market-cap weighted tracking approach with very low 0.07% annual costs
Threadneedle European Select: our long-standing top pick for Europe, this fund has a buy-and-hold approach focused on quality growth companies, with an emphasis on strong brands such as L'Oreal and Richemont. Ongoing costs of 0.83%
Jupiter European: an unconstrained and concentrated portfolio of 30-40 high growth companies. Annual charges of 1.03%
Baring Europe Select: a highly diversified portfolio of small and mid-sized European companies selected with a ‘Growth At A Reasonable Price’ (GARP) approach. Annual charges of 0.81%
Note: all charges based on those available via our Bestinvest Online Investment Service.