Faceoff: U.S. vs. European Equities

Summary

Podcast Summary: Thoughts on the Market – Episode: Faceoff: U.S. vs. European Equities

Introduction and Context

In the April 2, 2025 episode of Thoughts on the Market, Morgan Stanley’s Paul Walsh hosts a pivotal discussion featuring Mike Wilson, the Chief Investment Officer (CIO) and Chief US Equity Strategist, and Marina Zavolok, the Chief European Equity Strategist. The episode, titled "Faceoff: U.S. vs. European Equities," delves into the contrasting performances of U.S. and European stock markets, exploring whether Europe can maintain its recent outperformance or if a tactical reversal is imminent.

Year-to-Date Market Performance

Paul Walsh opens the discussion by highlighting Europe’s notable stock market outperformance compared to the U.S. This performance has been primarily driven by sectors such as defense and banking. In contrast, U.S. equities have experienced consistent weakness due to various well-documented factors. Walsh poses a critical question to Mike Wilson regarding the potential for a tactical rotation back into U.S. equities.

US Equity Market Analysis

Mike Wilson responds by expressing surprise at Europe’s substantial gains, attributing much of it to capital flows rather than a structural shift. He elaborates:

“I think the surprise for me anyways is just how much Europe has gone up. And I think a lot of that just has to do with flows and flows of capital.” [00:00]

Wilson underscores that the U.S. has been the top-performing market over the past decade, primarily fueled by large-cap growth stocks. He questions whether Europe’s outperformance is temporary or part of a more secular trend. He notes several headwinds that have impacted the U.S. market, including the Federal Reserve halting interest rate cuts in December, reversing fiscal impulses, and a slowdown in AI capital expenditures (CapEx).

European Equity Market Analysis

Transitioning to European equities, Marina Zavolok addresses the tactical situation following Europe’s strong performance. She emphasizes the critical role of earnings in sustaining market momentum:

“As we head into the 1Q earnings season a lot of investors are asking will Europe have this kind of outperformance in earnings that we saw last quarter?” [06:59]

Zavolok points out that European earnings revisions have outperformed the U.S., but notes that the current depreciation of the euro against the dollar is a headwind. She highlights Germany’s increased fiscal spending as a significant factor and compares it to the U.S. Infrastructure Investment and Jobs Act, suggesting that the next positive catalyst for Europe will be the release of detailed budget allocations expected in May or June.

Comparative Insights and Relative Performance

Paul Walsh probes further by asking Mike Wilson about the medium-term outlook for U.S. equities:

“How are you thinking about the outlook for the US Equity space as we kind of cast our gaze towards the end of this year and moving into 2026?” [04:44]

Wilson differentiates between the S&P 500 index and the average U.S. stock, praising the index for its quality and shareholder focus. He suggests that Europe could enhance its attractiveness by lowering taxes and regulations, potentially improving its relative opportunity set compared to the U.S. Wilson foresees a possible rotation of global investments back to the U.S. due to uncertainty and a shifting multipolar world.

Currency Exchange Impact

A significant portion of the discussion centers on the impact of currency exchange rates on earnings and market performance. Wilson explains:

“The dollar euro exchange rate which was very strong at the end of last year was a headwind for earnings growth for U.S. companies and a tailwind for European companies that now is reversed as the dollar has weakened substantially against the euro.” [01:34]

This reversal benefits European earnings relative to the U.S., potentially altering the earnings revision breadth between the two regions.

Tactical Opportunities and Strategic Outlook

Wilson identifies a tactical opportunity where the S&P 500 may offer an additional 3-5% of relative value over European stacks in U.S. dollar terms. He also warns of broader geopolitical shifts, such as the evolution towards a mercantilist environment and possible currency accords that could redistribute global assets away from the U.S.

Medium-term Structural Dynamics

Marina Zavolok discusses the structural dynamics underpinning European equities’ performance. She notes that the discount of European stocks versus the U.S. has remained within a stable downward range over the past decade. Zavolok believes that Europe may break out of this range in the second half of the year due to:

1. Repatriation of Investments: Investors moving away from concentrated U.S. indices back to Europe.
2. Diversification Themes: Potential shifts of global investments towards Asia and emerging markets.
3. Renewed Self-Reliance: Europe's focus on investing in its own future could drive a structural breakout.

“This kind of renewed self reliance of Europe investing in Europeans future, it can become a very bullish story.” [08:24]

Conclusion

The episode concludes with Paul Walsh thanking Mike Wilson and Marina Zavolok for their insightful analysis. He underscores the importance of understanding the relative merits of U.S. and European equity strategies, especially in a rapidly evolving global market landscape. Listeners are encouraged to share the podcast and leave reviews to support future discussions.

Notable Quotes

• Paul Walsh [00:00]: "Investors are asking if Europe can sustain its recent stock market outperformance against the U.S. or if we're poised for a tactical reversal."

• Mike Wilson [01:34]: "The key from my side is I sense you think there may be a tactical opportunity here and that we could be on the cusp of seeing something of a rotation back into US Equities."

• Marina Zavolok [06:59]: "The next positive catalyst we expect in Germany are going to be with the release of the budget when we get more details on how the money will be spent."

• Marina Zavolok [08:24]: "This kind of renewed self reliance of Europe investing in Europeans future, it can become a very bullish story."

Key Takeaways

1. Europe’s Outperformance: Driven by defense and banking sectors, supported by favorable earnings revisions and advantageous currency movements.
2. U.S. Market Challenges: Faced with policy rate stabilization, reversing fiscal impulses, and slowing AI-related investments impacting growth stocks.
3. Currency Impact: The weakening dollar against the euro is a critical factor benefiting European earnings in the current phase.
4. Tactical Rotation Potential: There is an anticipated 3-5% relative value opportunity in the U.S. S&P 500 over European equities.
5. Structural Shifts: Europe's potential to break out of its historical discount to the U.S. through increased diversification and self-reliance investments.

This comprehensive discussion provides investors with a nuanced understanding of the current dynamics between U.S. and European equities, highlighting both tactical opportunities and long-term structural considerations.

Transcript

[Paul Walsh]

Welcome to Thoughts on the Market. I'm Paul Walsh, Morgan Stanley's head of European Research Product, and I'm joined by my colleagues Mike Wilson, Morgan Stanley's CIO and chief US Equity strategist, and Marina Zavolock, our chief European equity strategist. Investors are asking if Europe can sustain its recent stock market outperformance against the U.S. or if we're poised for a tactical reversal. And today's episode is going to be a special kind of face off, looking at the relative merits of our US Equity strategy views against our European stock market views as well. It's Wednesday, April 2nd at 9:30am in London. Our clients love the face off work that we do. And I think today we've really got the ultimate face off looking at the relative merits of our US Equity strategy views and our European stock market views as well. So when I think about year to date, Mike, so I'm going to start with you. Europe's obviously done pretty well. I mean, we've seen clearly defense and banks being the main thrust of that performance relative to the U.S. and when we look at U.S. equities, and I think this has been very consistent, honestly, with the views that you've been expressing since the start of the year. There's been weakness there driven by a range of factors that I think everybody listening in will understand and are well documented. But the key from my side is I sense you think there may be a tactical opportunity here and that we could be on the cusp of seeing something of a rotation back into US Equities. So I wanted to hear your views, how they're evolving, and if you think there's a real tactical opportunity here.

[Mike Wilson]

I've not really been surprised at how the US Equity market has traded this year, given our view in the sequencing of policy. I think the surprise for me anyways is just how much Europe has gone up. And I think a lot of that just has to do with flows and flows of capital. So I mean, to me, the question for whether this is going to be, you know, kind of a structural change is like, what's really driving the outperformance in the near term? Is this something that is, you know, temporary, or is it something that's more secular and structural? And I think it's probably both. And, and the reality is is that it probably overshot a bit in the initial move here. And I want to just back up and kind of talk about the, you know, the US has been the, you know, the biggest outperformer for a decade, and it's been driven by, you know, kind of a handful of stocks or you know, the large cap growth segment. And I think it's interesting to just point out that that's a global phenomena, right? Meaning the high quality growth stocks in Europe have also done really, really well. It's just there's not as many of them. And similarly in Asia, the real story here is just that, you know, large cap quality growth and even somewhat defensive have just carried the day kind of post 2021 and but really over the last 10 years. And the question is why? Well, because, you know, organic growth has really not been that good. It's been very subsidized by government spending, other policy measures and you know, it's this crowding out feature that we've written about extensively. And that crowding out has led investors to essentially shun bonds and buy high quality stock. So now at the end of last year we had a couple of headwinds to this theme from a US Perspective. First off, the Fed stopped cutting interest rates in December. Number two, the fiscal impulse is reversing because it was unsustainable. The other one that doesn't get a lot of airtime, but some people have been talking about, including us is just the peak rate of change in AI CapEx really occurred in the fourth quarter and now it's decelerating. Doesn't mean we're up negative growth, it just means deceleration. But growth stocks key off of that. And that has driven revision breadth to be quite negative in the US for the first time really in several years and also on a relative basis. So I would argue that relative performance of Europe over the US Is really related directly to that relative earnings revision breath where Europe has been better relative to the US and then I think the bigger question is, is, you know, what happens after that. So we think there's, you know, another 3, 4 or 5% of relative value here for U.S. s and P500 over say Euro stacks in U.S. dollar terms. And then I guess I'd lastly just point out that the dollar itself was a big part of this move. The dollar euro exchange rate which was very strong at the end of last year and that was a headwind for earnings growth for U.S. companies and a tailwind for European companies that now is reversed as the dollar has weakened substantially against the euro. So I think Marina will talk about this as well. We believe that the relative earnings revision breadth between the US and Europe could reverse in Q1, really just on that currency exchange rate getting weaker now towards the dollar and Stronger for the euro.

[Paul Walsh]

Second question for you, Mike, before we move on to Marina, to understand the sort of tactical view around Europe you talked about, the bigger question is what happens after that? And you're referring to this sort of relative pickup in the US versus Europe. So I wanted to cast our eyes a little bit further out. How are you thinking about the outlook for the US Equity space as we kind of cast our gaze towards the end of this year and moving into 2026?

[Mike Wilson]

Well, I think that there's two ways to think about this. First of all, it's the index itself or the S&P 500, the highest quality index in the world, versus, say, the average stock. Okay. And, you know, a lot of things have helped the S&P 500 that are unique. Lower tax rates in the US think about the operational efficiency of which companies have operated in the U.S. they're a little bit more, I think, shareholder focused. And so the question is, could there be a reversal in some of those relative trends? And I think the answer is yes. Meaning Europe could lower taxes, they could lower regulation, they could create incentives for businesses to operate more freely. And those two, on a relative basis, even if the US just keeps doing what they've been doing, the relative opportunity set looks a little bit larger. So I think there's an opportunity for two things to happen. The average company could do better than, say, the index. Once we had this transition, which is going to take another probably six or 12 months, and then secondarily, we could see a diversification of ownership away from the US Back towards other countries, not just Europe, by the way. That could be Asia. That could be emerging markets. And I think the key there is going to be what happens to the US Dollar. So even if you don't believe this story, a global investor needs to be rotating back. You know, they need to have better diversification in their portfolio because it is going to be an uncertain world for probably a period of time as you go through a major transition here, this multipolar world that you know is continuing to evolve, maybe back to a mercantilist type environment, something we haven't seen in 30 years. And then the currency, there could be some sort of a currency accord which would force the redistribution of assets away from the US to other parts of the world.

[Paul Walsh]

Mike, thanks for that. How are you thinking, Marina, about the tactical situation here for European equities after this strong run that we've seen so far this year?

[Marina Zavolok]

The key question that we're getting is about earnings. So as we head into the 1Q earnings season a lot of investors are asking will Europe have this kind of outperformance in earnings that we saw last quarter? So just to remind last quarter, European earnings revisions breadth really outperformed the US they basically diverged in opposite directions going into this earnings season. You literally have the opposite dynamics. So you have the dollar that's depreciated by about 5% that's not going to flatter. European earnings versus the US the last thing I'll mention here is that on this kind of higher spending and excitement on Germany, we really like Germany structurally. We think that this increased fiscal spending is a game changer. But we've also done a lot of analysis comparing to the Infrastructure Investment and Jobs act in the US and basically have found that what you tend to have at this point of the recent rally that you had in exposed stocks to, for example the infrastructure fund is a travel and arrive situation. And pretty much the next positive catalyst we expect in Germany are going to be with the release of the budget when we get more details on how the money will be spent. And that's not until May or June.

[Paul Walsh]

Okay, thanks for that, Marina. So you've laid out I think very clearly the tactical view on Europe. How should we also be thinking about the medium term sort of structural dynamics for European equities in that sort of relative global context?

[Marina Zavolok]

One thing we like to track really closely is the like for like discount of Europe versus the US and the reason we track it closely is because this discount travels within a pretty stable downwards range. So over the last 10 years or so we've seen European discounts versus the US widening structurally and they've been doing that within a range. And the question for me, which I think you're asking is are we going to break out of this range? I don't think we're going to break out at this very moment, but I think it is possible that we break out possibly in the second half of this year. I think there are a lot of important dynamics and you know, changes, let's say, happening in Europe. I think that's really important because part of the reason Europe's outperformed is because investors are worried about the level of concentration of the US and their indices. So if you have this kind of dynamic of repatriation back to Europe and you have this continued diversification theme later this year, I think after we pass this earnings season, that could propel Europe to maybe structurally breakout versus the US rather than just have a tactical rally. So this kind of renewed self reliance of Europe investing in Europeans future, it can become a very bullish story. So I don't think this kind of tactical pullback we're seeing right now is the end of the story.

[Paul Walsh]

Mike Marina, thank you both very much for taking the time to talk, and to our listeners out there, as always, thank you for taking the time to tune in. If you enjoy thoughts on the market, please do leave us a review wherever you listen, and be sure to share the podcast with a friend or colleague today.

[Marina Zavolok]

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