On the face of it, Europe, speaking broadly, and the U.S. share many obvious similarities. They are developed economies with substantial technological penetration, so productivity between the two regions should theoretically be similar. They are aging societies, with the demographics and trends of the labor markets of both regions moving in tandem. But something caused these markets to diverge in recent years. What is causing the gap – and does it lead to any investment opportunities?
To begin, the value of the U.S. stock market relative to the U.S. economy had a fairly similar ratio as that of the European stock market relative to the EU economy. Measuring the value of the stock markets in both regions relative to their respective GDP controls for any differences in economic growth between the two regions. And for the most part, these ratios for Europe and the U.S. had largely moved in tandem, closely correlated with each other.
That changed in 2012, when European stocks began lagging their American peers, expressed in terms of the ratio of each stock market index relative to its local GDP.
Since we’re controlling for differences in economic growth, we’re capturing the prior woes of countries such as Greece, Portugal, and other headline issues of years past. So, what else may have triggered this disconnect between the two, beginning about 2012?
The U.S. dollar is correlated to emerging markets
The answer may be surprising: The U.S. dollar is where some of the differences between the U.S. market’s performance and Europe’s market starts. The USD is inversely correlated to emerging markets – especially so now, considering the large role the dollar has in making the dollar-denominated debt of many of those countries difficult to repay. That has strained the economies of many emerging markets, some of which also have political issues with which they are grappling, as well as commodity price fluctuations.
European banks are correlated to emerging markets; U.S. banks are not
But emerging markets don’t borrow just in dollars. European banks in particular have sizable loans to emerging markets, so European banking stocks are correlated to emerging market stocks. European banks are much more integrated into emerging markets’ economies than U.S. banks are, with notable exposure on some banks’ balance sheets.
U.S. bank stocks, by comparison, are not at all correlated to emerging markets, which is not surprising, given that U.S. banks don’t have sizable EM loan portfolios.
Broader markets are correlated to banking sector stocks
So, now that we’ve identified a linkage between emerging markets and European banks – but not for U.S. banks – what does this mean for the broader markets?
The banking sector is the lifeblood of any economy. From it, capital must be transmitted to corporations and consumers, whether to buy a house or build a factory. The U.S. Federal Reserve and the European Central Bank certainly recognize the instrumental role banks play in an economy, so both central banks have pumped trillions of dollars and euros into their economies as economies struggled after the financial crisis.
Before going further, though, we must clarify an earlier point, that of looking at markets relative to GDP to control for growth. That is a comparison of actual, contemporaneous economic output at the time of measurment. What it doesn’t measure, however, is the future growth potential that can be afforded by a stronger banking sector – an important factor since markets are forward looking.
Indeed, as bank stocks in either the Europe or the U.S. go, so too did the broader markets in both regions. Thus, a key difference between the U.S. and Europe is the tight link between the fate of emerging markets and the banking sector within Europe – but not in the U.S. – creates a linkage to problems in emerging markets in Europe that we just don’t have here.
After all, stress in any region where a bank lends can place capital constraints on that bank’s ability to lend in other markets, which can be a damper on growth. This may limit the success of the ECB’s pass through of its stimulus program with ultra-low lending rates from fully benefiting he Eurozone economy.
We can see how these relationships exist by simply comparing bank stocks with the broader market. In the U.S., an index of banking stocks published by Standard and Poor’s is tightly correlated to the S&P 500.
Meanwhile, for Europe, we can see a similar relationship, using measures published by MSCI for both banking stocks and Europe as a whole (measured in local currencies). There has been a bit of a divergence in the past couple of years, however, as trade (particularly with the U.S.) has benefited European stocks even while the European banking sector pulled markets lower.
Does this divergence automatically create opportunities?
So, the bottom line question that some investors may ask is, “Does this divergence between the U.S. market and European stocks present an easy opportunity?” To answer that, we need to review the steps of correlation and causation from each of the variables above:
Add in all the other variables affecting the price of an individual share of stock – corporate profits, interest rates, trade exposure, etc. – and you have a complex picture of multiple drivers. So, if we were to look simplistically at the divergence of U.S. markets to European markets, and believe there to be an opportunity simply because of the gap in relative valuations, we might blindly allocate funds to Europe. But the answer is much more complicated than that, and bottom-up research of individual companies is arguably paramount to simply trading a regional ETF.
In short, investors must do their homework – there are no simple answers. After all, if this was an easy profit opportunity, investors would already have rushed in to fill that valuation gap.
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