Indrani De
Mark Barnes
Zhaoyi Yang
European stocks have left most of their global peers in the dust throughout the relief rally that began last October. After suffering bigger losses than other major markets in last year's sell-off, the developed Europe index catapulted into the lead in the final quarter and has extended its gains into the new year.
The FTSE Developed Europe index leapt 10.6% in Q1, surpassing the respective increases of 7.7% and 7.3% for the FTSE USA and FTSE All-World and tipping into positive territory for the 12-month span.
Global equity index returns (rebased, USD)
Source: FTSE Russell. Data through March 31, 2023. Past performance is no guarantee to future results. Please see the end for important disclosures.
Developed Europe – the diversification destination?
Many of the factors driving Europe’s recent strength seem likely to hold going forward.
Although inflation is easing and long yields appear to have stabilized or are near peak, chances are that interest rates are likely to remain higher for some time longer than they did in the previous stretch of central-bank tightening. The current long-dated government bond yield in the US is higher than in the Eurozone, reflecting the earlier start and more aggressive pace of rate hikes by the Federal Reserve compared to the European Central Bank (with respective increases of 475 bps versus 350 bps, even though Eurozone inflation has been running hotter than in the US since last July).
At a time when interest-rate moves and monetary policy have become key drivers of equity markets, this yield differential can be viewed as a plus for European stocks, as they benefit from a lower discount rate than their US counterparts.
FTSE US Government Bond 7-10 Years Index and FTSE EMU Government Bond 7-10 Years Index (%)
Source: FTSE Russell. Data through March 31, 2023. Past performance is no guarantee of future results. Please see the end for important legal disclosures.
Demographics is another factor working in favor of European stocks. Populations are aging in most developed countries, as well as in large emerging nations such as China. The investment priorities of people nearing or in retirement tend to be skewed more toward income-generation and capital preservation than capital appreciation.[1] These issues, in turn, have fueled a global investor flight to less volatile, perceived ‘safer’ assets, driving demand for government bonds, higher-quality corporate credit and stable, high-dividend-paying equities.
Empirical research further suggests that future investment returns are likely to be lower than those seen since the Global Financial Crisis.[2] If that proves true, dividend yields would become a much bigger share of total equity returns, adding to the appeal of the European stock market, which currently pays a dividend yield of 3%, much higher than the 1.7% yield in the US.
Dividend yields (USD %)
Source: FTSE Russell. Data as of March 31, 2023. Past performance is no guarantee of future results. Please see the end for important legal disclosures.
Moreover, though investor anxieties have eased since the banking-sector crisis in mid-March, markets are likely to remain volatile given lingering uncertainties about the outlooks for global economic growth and the path of monetary policy. In such times, diversification is an investor’s best defense.
This is also an area in which the European stock market shines. The Developed Europe Index is far more diversified by industry exposure than its global peers. The three largest industries (Financials, Industrials and Health Care) each account for roughly 15-17% of the index, while another two (Discretionary and Staples) each comprise 11-13% − offering a nice balance between cyclical and defensive characteristics.
By contrast, the US equity market is heavily concentrated: Technology makes up nearly 30% of the FTSE USA index, while Consumer Discretionary, the next runner-up in scale, accounts for 14%. Financials are only a 10% share of the US index.
Regional index industry weights (%)
| Industry | US | Dev Europe | Emerging | Developed | All World |
|---|---|---|---|---|---|
| Basic Materials | 1.9% | 5.6% | 7.5% | 3.7% | 4.1% |
| Consumer Discretionary | 14.1% | 13.3% | 13.0% | 14.1% | 13.9% |
| Consumer Staples | 5.8% | 11.4% | 6.6% | 6.6% | 6.6% |
| Energy | 4.8% | 6.2% | 5.9% | 5.1% | 5.2% |
| Financials | 10.1% | 16.5% | 21.7% | 13.1% | 14.0% |
| Health Care | 13.6% | 15.2% | 3.8% | 12.8% | 11.9% |
| Industrials | 12.2% | 16.4% | 7.8% | 13.7% | 13.1% |
| Real Estate | 2.7% | 1.0% | 2.5% | 2.6% | 2.6% |
| Technology | 29.3% | 7.3% | 23.8% | 22.4% | 22.6% |
| Telecommunications | 2.6% | 3.0% | 4.2% | 2.7% | 2.9% |
| Utilities | 3.0% | 4.1% | 3.1% | 3.1% | 3.1% |
Source: FTSE Russell. Data as of March 31, 2023. Past performance is no guarantee of future results. Please see the end for important legal disclosures.
Can Europe’s winning streak last?
To understand Europe’s recent outperformance, particularly versus the US, it is instructive to look more deeply into how these compositional differences have played out in response to the big shifts in the economic and interest-rate backdrop and risk appetite over the past year.
Two of the four equity industries that have dominated the headlines this past year are Technology and Financials, which tend to be affected in polar-opposite ways by moves in interest rate. Rising rates have clearly hurt pricey Technology and other growth stocks. However, such moves are typically a positive for Financials, though the effect is more nuanced for that stock group, with both the level and slope of the yield curve playing important roles.
Select FTSE All-World industry index returns (rebased, USD)
Source: FTSE Russell. Data through March 31, 2023. Past performance is no guarantee of future results. Please see the end for important legal disclosures.
Even though rising rates affect Technology and Financials in contrary ways, both stock groups in Europe have strongly outpaced peers in the US and globally and were instrumental in propelling the European index higher since October. They may continue to be important drivers in the months ahead.
Regional Technology and Financials index returns (rebased, USD)-Technology
Regional Technology and Financials index returns (rebased, USD)-Financials
Source: FTSE Russell. Data through March 31, 2023. Past performance is no guarantee of future results. Please see the end for important legal disclosures.
Europe sees strong inflows
Investor conviction in European equities has enjoyed a strong resurgence in recent months, as indicated by the Lipper fund flows data below. Flows into developed Europe have picked up strongly since late 2022, while North America (dominated by the US) has continued to see outflows.
Regional cumulative equity fund flows (rebased)
Source: FTSE Russell. Data through March 31, 2023. Rebased at 100 back to the first month (April 2022). Past performance is no guarantee of future results. Please see the end for important legal disclosures.
The European stock market has been benefiting of late from its value tilt and solid defensive characteristics, underpinned by its relatively generous dividend yield and broad industry diversification – and these attributes may continue to play a role as investors navigate the challenging macroeconomic environment ahead.
[1]Investors Stay Upbeat on Private Equity, Credit, Wall Street Journal, April 18, 2023.
[2] Investing Amid Low Expected Returns: Making the Most When Markets Offer the Least, Ilmanen, Antti, Wiley (April 12, 2022).
For more on global equity performance, please see our latest Market Maps Performance Insights report.
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