Should investors favour European or US equities?

European equities

Robert Farago, Head of asset allocation at Schroders Private Bank

Growth in the United States of America is outpacing the not-yet-united states of Europe. For the time being we expect this to continue as long as the US can avoid falling into the fiscal Grand Canyon looming ahead. However, we believe that European equities now represent a better long-term investment, although investors should expect a bumpy ride along the way.

European equities are the poor relations, having suffered a prolonged period of underperformance relative to the US. Relative performance against the US market hit the bottom of a 40-year trading range earlier this year, despite trend earnings growth having been similar between the two regions over the long-term. Productivity gains have also been broadly in line and the overall levels of government borrowing are, if anything, in Europe’s favour. The moves by the ECB to do “whatever it takes”, and tacit acceptance of this from Berlin, mean the odds of disaster striking the euro area have reduced. We believe that this European market underperformance should start to reverse.

The US remains a more vibrant economy than Europe, and has the prospect of greater energy independence thanks to rapid growth in gas reserves. While we expect it to continue growing faster than Europe in the near term, this depends on the authorities’ ability to reach compromise to avoid the full impact of tax increases and spending cuts that are mandated to occur at the start of the year. We are confident that an agreement will eventually be reached but it is 50:50 at this point as to whether this happens before the end of the year or if the US must head over the ‘fiscal cliff’ first.

The outlook for Europe, meanwhile, is far from sunny in the short term. A euro break-up remains the biggest single threat to the world economy. The euro area is expected to suffer a continuing recession in 2013 and this will restrain growth in the UK economy too while the slump in Spain is worsening.

However, the good news is that restructuring is happening, even if the plans leave something to be desired. Governments in peripheral Europe are introducing austerity measures and cutting spending. Even Greece produced a positive surprise this month by posting a current account surplus in September. But the path to recovery requires economic growth as well as spending cuts, and a policy to generate this growth is missing. A shift away from outright austerity and towards some form of growth policy seems likely in 2013. There is a clear risk that a continuation of current trends will lead to further civil unrest and a move towards more extreme politics.

Valuations are also in Europe’s favour. European equities look cheaper than US equities on every measure, both on current earnings and on long-term trend earnings. In particular, Europe offers a higher yield at a time when the US is considering dividend tax increases.

That said, it must be remembered that Europe is cheap for a reason. A break-up of the euro would be disastrous for the region (and indeed for the world). Right now that looks like a long shot for the next year or two, but it remains a genuine threat.

The example of the US election is a reminder of the power of hindsight. A fortnight before the election it was deemed one of the most closely fought elections in US history. Yet the day after the result was known, an Obama win was suddenly seen as having been inevitable all along. The risk for anyone buying Europe today on behalf of their clients is that, if it goes wrong, it will be impossible to deny that the risks were there and they will seem so obvious that you will look like a fool for having gambled on any other outcome.

We are confident that the valuation gap will ensure that Europe outperforms the US over the next decade. But we may still have to visit newfound depths of despair first.

Oliver Gregson, Barclays Wealth

US equities 

Oliver Gregson, Director, Barclays Wealth & Investment Management

Despite outperforming the market year to date, developed equities remain among the most attractively valued of the main asset classes. However, with risk still rife, it is clear that some developed markets are more uncertain than others.

While the eurozone grapples with its continuing crisis, the US recovery, although sluggish, has now persisted for almost three years. Following the outcome of the US election, Congress remains divided and the market has turned its attention to the ‘fiscal cliff’. Although this is certainly a threat to the region’s recovery, we believe there is a strong chance that the issue will be resolved by early next year. That said, politics is likely to drive market volatility over the near term as the ideological divide between the Democrats and the Republicans becomes apparent in how they attempt to deal with ‘the cliff’. This is likely to dominate economic sentiment and overshadow the fact that US GDP growth for the third quarter came in ahead of expectations.

A surge in consumer spending, along with stronger-than-expected industrial production and manufacturing, drove a 2 per cent uptick in economic growth. This came amid signs that the housing market is staging its own tentative recovery with residential construction up 14.4 per cent. These indicators are important because they point towards the possibility of a virtuous cycle emerging between the housing market, consumer confidence, jobs growth and ultimately expenditure. While the recovery in employment has been disappointing, the

private sector has added more than four million jobs over the course of this recovery. Meanwhile, as companies diligently repair their balance sheets, estimates suggest that the US corporate sector is sitting on significant amounts of cash which it will eventually put back to work.

Looking at the sector from several other metrics – including price to book, price to forward earnings, and price to cash flow – US equities look inexpensive relative to their long-term average. While questions remain on the relevance of that comparison, headwinds are unlikely to drift away in the near term and the key question for investors going forward is whether the corporate sector has reached peak margins – US sequential EPS growth is currently negative for the first time in three years.

US corporates are increasingly well positioned to compete in the global market for manufacturing and exports. This relates to what we are calling the American Industrial Renaissance. The offshoring story that was rife 10, 20 years ago – and saw jobs and services outsourced abroad – is now starting to reverse. This comes amid a levelling off of US wage costs, favourable demographics, a cheap property market and improved relative energy costs. After the slowest-growth decade in half a century, it is quite likely that trend growth is stabilising – and this is a possibility which, in our view, is still not priced into capital markets.

Investors looking to increase exposure to the US must focus their decision on two overriding questions: What percentage of my portfolio should be allocated to US equities? And how should this position then be implemented?

In the current climate, we believe that a moderately risk-tolerant portfolio should have a US equity exposure of approximately 27.5 per cent. In terms of implementation, those looking for active management would, in our view, have a higher potential to outperform by combining a strong ‘value-style’ manager with a ‘growth-style’ equivalent. For investors who are not looking for an actively managed solution, we would suggest an ETF. These are, in our view, a good way to express short-term tactical views, such as our current overweight position on US equities, as they are quick to transact, liquid, cost effective and transparent.