Even as some European stocks give U.S. equities a run for their money this year, investors still give the region’s companies a lower valuation than their counterparts across the Atlantic. There are signs, however, that could change, according to Goldman Sachs Research.
The STOXX Europe 600 Index has rallied about 8% and the DAX Index of German equities has risen 14% in 2023, compared with the U.S. S&P 500 Index’s 12% gain. But European stocks continue to trade at a larger-than-normal discount to those in the U.S., and European equities are changing hands at about 13-times forward consensus earnings, versus about 19 times in for their U.S. counterparts. That discount is the largest it’s been in more than a decade, and well below the 20% median over the past 20 years.
The reasons go beyond mix of sectors that are dominant in each region. While Europe has fewer technology companies that demand higher multiples from investors, every sector in Europe is currently trading at a discount to its peer sector in the U.S., according to Sharon Bell, a senior strategist on the European Portfolio Strategy team.
“That valuation gap has gotten very large, and I think it’s undeserved,” Bell says. “There are various ways that gap could narrow over time.”
Bell says there are a number of reasons that U.S. and European valuations have gotten out of synch. The global financial crisis hit Europe’s financial-heavy indexes particularly hard. Since then, a boom in innovation and technology investment in the U.S. positioned American companies to take better advantage of a period of low interest rates, pushing the market capitalization of U.S. stocks to 2.6 times that of those in Europe, the highest that gap has been since the early 1980s. The U.S.’s listed tech sector is 10 times bigger than Europe’s — and that sector does not include mega-cap companies like Amazon, Meta or Tesla, which are classified into other sectors.
A smaller investor base in Europe has also contributed. Relative to the size of GDP, equity markets in Europe tend to be smaller than in the U.S., largely due to a lack of depth among domestic investors. Europeans allocate more capital to housing and other investments than to stocks, compared with their American counterparts, and pension and insurance company equity allocations have declined sharply in recent years.
While these factors are well entrenched, Bell thinks the valuation gap between U.S. and European companies could soon narrow. She points to a handful of factors — including shifting investor sentiment about market risks, higher interest rates and profit margin reversion in the U.S., and an improving regulatory backdrop in Europe—that could push European stock prices higher and narrow the valuation gap.
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Higher interest rates in the U.S.: The U.S. market benefited more than Europe from lower rates given its bigger share of tech and high-growth companies, but stands to suffer more if rates stay higher this cycle, as Bell and the team expect. In addition, the U.S. private sector tends to be more vulnerable to higher lending costs given its low savings rate and higher debt levels. Higher yields are also encouraging more U.S. investors to shift their capital to money market funds.
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An improving regulatory and risk backdrop: Stringent stress tests, high capital ratios and other banking rules have made European banks more resilient. At the same time, corporate tax rates have fallen for European companies. Also, the risks around sovereign credit in Europe seem to have receded with the European Central Bank’s commitment to cushion sovereign spreads through targeted asset purchases should the need arise.
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More global representation: If investors do look to diversify further outside the U.S., European companies will likely benefit. Overall, nearly 60% of European company sales are outside Europe, compared to just 29% of U.S. company exposure in non-U.S. markets. European-listed companies are also more global than companies listed in other regions when it comes to investment and assets, according to Goldman Sachs Research. Foreign investors are steady buyers of European equity, and fund flows have picked up in recent years. In addition, non-U.S. markets tend to perform better when the dollar weakens, and the dollar is overvalued based on longer-term models.
- Profit margin reversion: Profit margins and the profit share of GDP are both exceptionally high in the U.S., and these lofty levels might not hold, Bell says. Labor groups in the U.S., for example, are pushing for a higher share of economic output. “The pie isn’t being divided equally—in fact, it’s particularly unequal at the moment and there’s a growing risk that’s not sustainable,” Bell says. The underperformance of European earnings relative to U.S. companies stopped around 2020, according to Goldman Sachs Research. Europe’s high share of strong defensive-growth companies and improvement in business models in banks, telecoms and utilities has lifted overall earnings.
- Buybacks and takeovers: Stock buybacks in Europe have risen to multiyear highs as companies look to improve their valuations by shrinking the supply available to the public. This is happening especially in energy and financials, where the valuation gaps are the biggest compared to their U.S. peers. Takeover bids targeting European companies could also spur prices higher. Recent private equity bids in the U.K. highlight the potential for public equity to be taken private by global PE investors with plenty of capital to deploy, Bell says. “Foreigners using their dollars to go and buy cheap European assets because they look inexpensive—that would up the valuation of European companies,” Bell says.
Taken together, these factors point to more favorable outlook for European equity markets relative to the U.S., according to Goldman Sachs Research, and our strategists predict the STOXX Europe 600 will outperform the S&P 500 Index in 2023. “Even if the valuation gap doesn’t close, the U.S. is unlikely to continue to massively outperform Europe,” Bell says. “Investors are showing they want to diversify their risk. And that’s going to continue to benefit Europe.”