European Stocks Lose Momentum as US Rallies Confidence

The prospect of European stocks outperforming their US counterparts is waning, as concerns about an economic slowdown dampen the outlook for earnings.

After a brief period of outperformance, investors are increasingly turning their attention to undervalued sectors in the US market. This shift is driven by data indicating the resilience of the US economy and expectations that the Federal Reserve will cut interest rates sooner and more aggressively than previously anticipated.

While European stocks have shown strength, with the Stoxx 600 reaching record highs, the index underperformed the S&P 500 in August. Over the course of 2024, the Stoxx 600 has lagged behind by nearly 9 percentage points, marking the second consecutive year of underperformance.

“US stocks remain more attractive even at higher valuations, as the earnings growth potential is also higher,” said Evgenia Molotova, a senior investment manager at Pictet Asset Management Ltd. She noted that Europe’s greater reliance on Chinese imports puts it at a disadvantage in the event of a global recession.

Global stocks have been rebounding after fears of a potential US economic contraction led to a selloff in early August. Tech stocks were particularly hard-hit, as investors questioned whether valuations had outpaced the benefits of significant spending on artificial intelligence. Initially, European stocks seemed poised to benefit from the shift away from tech, particularly following underwhelming quarterly reports from members of the “Magnificent Seven” such as Amazon and Alphabet.

Bolstered by the European Central Bank’s first rate cut, a Bank of America survey in July indicated that a net 60% of fund managers expected European stocks to gain over the medium term. However, sentiment turned more pessimistic in August as investors increasingly shifted focus to previously overlooked areas of the US market. The S&P 500 equal-weighted index, which reduces the dominance of tech mega-caps, outperformed the Nasdaq 100 for the second consecutive month in August, marking its longest streak of outperformance since the end of 2022.

A brief period of optimism for European stocks was reflected in two weeks of $500 million in inflows following 13 consecutive weeks of outflows. However, this trend reversed with $800 million being redeemed in the seven-day period ending 28 August, according to Bank of America strategists citing EPFR Global data.

One of the biggest challenges facing Europe is its economic growth outlook. Germany’s GDP contracted in the second quarter, with sentiment particularly downbeat in the key industrial sector. Additionally, an uneven recovery in China—a crucial market for European industries such as luxury goods and automakers—has weighed on earnings. A Citigroup index shows that economic data across the euro area has increasingly disappointed since June, in contrast to a recent pickup in the US.

“When you worry about growth, you go for the part of the market that provides growth,” said Beata Manthey, an equity strategist at Citigroup, who expressed a preference for US stocks. Manthey noted that she would need to see upgrades to corporate earnings estimates and reduced political uncertainty before becoming more optimistic about European equities. Currently, analysts’ estimates for Stoxx 600 profits over a 12-month horizon have remained relatively flat since June, while forecasts for the S&P 500 continue to rise.

Despite these challenges, some investors see potential for European outperformance due to its continued valuation discount. The Stoxx 600 trades at about 14 times forward earnings, compared to 21 for the S&P 500, according to Bloomberg data.

“There are good reasons for saying the European performance should be less volatile and perhaps a bit stronger than the US because the starting point in valuations is very different,” said Guy Stear, head of developed markets strategy at the Amundi Investment Institute. However, Stear emphasized that sustained optimism on economic growth and corporate earnings into 2025 would be needed to support continued investment in European equities.

“Is there a catalyst immediately tomorrow? Possibly not,” Stear concluded.