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 US or if we are 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 the 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 gonna 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 US. And when we look at US 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 and 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 equity. 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 the reality is that it probably overshot a bit in the initial move here.
And I wanna just back up and kind of talk about the US has been 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 phenomenon, 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; but really over the last 10 years.
And the question is why? Well because 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 stocks. 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.
It doesn't mean we have negative growth; it just means deceleration. But you know, growth stocks key off of that and that has driven revision breath to be quite negative in the US for the first time, really in, you know, several years. And also, on a relative basis.
So, I would argue that a relative performance of Europe over the US is really related directly to that relative earnings revision breadth, where Europe has been better relative to the US.
And then I think the bigger question is, you know, what happens after that? So, we think there's another 3, 4, 5 percent of relative value here for US S&P 500 over say Euro stocks in US dollar terms. And then I guess I'd lastly just point out that the dollar itself was a big part of this move; a dollar Euro exchange rate, which was very strong at the end of last year.
And that was a headwind for earnings growth in US, for US companies and a tailwind for European companies. That now is reversed, as a dollar has weakened substantially against a Euro. So, I think, you know, Marina will talk about this as well. You know, 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, you know, the bigger question is what happens after that? And you are 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, you know, operated in the US. They're a little bit more, I think, shareholder-focused.
And so, the question is, you know, 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, you know, 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 gonna 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 gonna be what happens to the US dollar.
So even if you don't believe this story, a global investor needs to be rotating back. They, they need to have better diversification in their portfolio because it is gonna be an uncertain world for probably a period of time as you go through a major transition here. This multipolar world that, 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 Zavolock: The key question that we're getting is about earnings.
So, as we head into the one 1Q earning 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 diverge in opposite directions.
Going into this earning season. You literally have the opposite dynamics. So you have the dollar that's depreciated by about 5 percent. That's not gonna 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 in 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.
So 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 Zavolock: 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 gonna break outta this range?
I don't think we're gonna 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 in 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 earning 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 European's future, it, 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.
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