Strong Euro, U.S. tax cuts and growth of American tech firms are among reasons for earnings gap
The Eurozone’s economy has outpaced the U.S. for the past two years, yet its corporate profits are trailing those in America like never before.
The bloc posted its strongest economic growth in a decade last year, inspiring investors to pour billions into European exchange-traded funds following the 2017 French election.
European earnings have increased since then, but the U.S. has grown much faster—with the gap in earnings per share
between MSCI’s USA and Europe indexes ballooning to a 30-year high, according to Mislav Matejka, equity strategist at JPMorgan.
A stronger euro, large U.S. tax cuts and surging growth from America’s tech giants have caused most of that gap.
“Europe had a very good year of profit growth, but the U.S. was on steroids,” said Karen Olney, head of European thematic equity research at UBS.
Now investors are debating whether Europe is set for a catch-up as the tax effects wash out and the U.S. dollar regains its footing, or whether a recent slowdown in the region’s economic data portends a bumpier road ahead.
Companies in the S&P 500 are on track to grow their earnings by 25% in the most recent quarter, compared with just 6.5 % for the Stoxx Europe 600, according to FactSet.
Throughout the reporting season, U.S. companies have been surpassing expectations, with 78% of S&P 500 companies beating earnings-per-share forecasts through Friday, on pace for the most positive surprises in the nearly 10 years this data has been tracked.
That compares with just 43.7 % of Stoxx Europe 600 companies beating earnings forecasts, the lowest percentage since 2015, according to FactSet.
European profitability has taken a hit from a roughly 15 % gain in the euro between the start of 2017 and 2018. Companies in the Stoxx Europe 600 generate about half of their revenues outside of Europe and a stronger local currency cuts into the earnings of multinationals.
Paul Markham, global equities portfolio manager at Newton Investment Management, said he watched the euro strengthen against the dollar at the end of last year and sold down part of his European equity position.
“The resurgence of the euro has been quite negative for the competitiveness of the global companies listed there,” he said.
The size and explosive growth of American technology companies have also been an important factor leading to U.S. outperformance. Roughly a quarter of the S&P 500 by market value is part of the technology sector, compared with just 4.7 % of the Stoxx Europe 600. Over 90 % of companies in the U.S. tech sector have exceeded analysts’ earnings forecasts this quarter.
Since the peak of the last profit cycle, roughly a decade ago, the gap in earnings between the U.S. and Europe has grown to 70 %, said Ms. Olney. But removing the technology and financial sectors from the equation shrinks the gap to 27 %, she found. European banks have lagged behind the U.S. over that period as the region struggled to recover from a debt crisis and ultralow interest rates cut into their profitability.
Despite the gap in earnings, European equity indexes have performed roughly in line with those in the U.S. this year. The Stoxx Europe 600 and S&P 500 are both up about 2 % for 2018 and the Dow Jones Industrial Average is up around 1 %.
Some investors expect European earnings to catch up in the coming quarters. The euro has fallen roughly 2 % against the dollar so far this month, reassuring some investors the peak hit to earnings has passed.
“There are signs Europe is in the best position it’s been in in recent years to turn that tide,” said David Holohan, equity investment strategist at Mediolanum Asset Management, pointing to rising input costs in the U.S. that could pressure margins.
On the flip side, U.S. earnings growth is forecast by analysts to slow down in 2019 and in 2020 as the impact of tax cuts fades out of comparisons.
For U.S. earnings, “there is this fear of is this as good as it gets,” said Katie Nixon, chief investment officer at Northern Trust Wealth Management. While she likes U.S. equities, she prefers those in Europe and emerging markets.
But others remain skeptical. Only a net 6 % of fund managers expect improving profits in the eurozone, compared with 38 % for the U.S., according to Bank of America Merrill Lynch’s May survey.
Eric Freedman, chief investment officer at U.S. Bank Wealth Management, said he started the year with a large portfolio weighting to European stocks but has since cut back. “A lot of the high-frequency [economic] data we look at in Europe has been weakening,” he said.
The Citigroup Economic Surprise Index for the eurozone, a widely tracked measure of how data expectations are being met, fell to -101 earlier this month, its lowest since 2011, around the time of the European debt crisis.