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Roula Khalaf, editor of the FT, picks her favorite stories in this weekly newsletter.
The author is a former chief investment strategist at Bridgewater Associates
European stock markets are starting 2024 following a familiar pattern: They are underperforming in local currency terms than their US competitors. Between 2009 and 2023, such underperformance resulted in cumulative gains in the S&P 500 that were five times greater than those in the Euro Stoxx 50.
Such exceptionalism in US stocks has not always been the case. In the two decades before 2009, stock returns in the US and Europe were much more similar. Investors should look back to understand what changed this relationship and how these factors might evolve in the future.
It is now common knowledge that advances in technology and large U.S. tech stocks have been a key driver of outsized U.S. market gains over the past decade. Investors are also aware of some other factors that are weighing comparatively more heavily on European economic and market performance. The list includes the war in Ukraine, more limited post-pandemic stimulus, the slowdown in trade with China and, even further back, the impact of the European debt crisis and a subsequent recovery limited by a government spending pact.
There is another structural cause of Europe's poor performance that is likely to persist: the European financial sector. This is not about the stock performance of regional banks. Rather, Europe's relatively narrow and fragmented financial industry resembles a weak financial heartland that struggles to pump sufficient capital and liquidity to support healthy European businesses and economic growth.
The gap between the US and European financial sectors has steadily widened since the 2008-2009 crisis, in which banking regulation was significantly tightened. In fact, according to a recent study by the Official Monetary and Financial Institutions Forum, a think tank, the total market capitalization of European banks (including the UK and Switzerland) has increased from $2.7 trillion in 2007 to $1.4 trillion in 2021 sunk. The decline in Europe is even more striking when compared to the increase in market capitalization of US banks: from $1.6 trillion to $2.6 trillion. Asset management firms experienced even greater divergence over the same period, with the European asset management sector losing market share, in part to the US industry, which has now become globally dominant.
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Although size does not guarantee relatively higher market returns or corresponding economic growth, it certainly helps companies more easily absorb the costs associated with changing regulatory and technology requirements. The size and breadth of U.S. financial firms also create a positive feedback loop with capital markets that support a more robust ecosystem across the economic cycle. Larger, healthy banks can make more loans, which supports businesses and overall economic growth. This economic growth, in turn, creates a positive environment for investment by households and businesses, which benefits both banks and promotes the development of capital markets and non-bank financial companies. These non-bank options offer more investment and financing opportunities – which is particularly helpful when macroeconomic conditions or regulations cause banks to temporarily curb lending, as was the case last year.
Stricter regulations after 2008 are far from the only reason why they are holding back European financial markets. Cultural and political issues also contributed. Despite the successful introduction of a single market and a single currency, European politicians have so far failed to transform decades of discussions into effective banking and capital markets unions.
The lack of buy-in from policymakers is often due to differences in voter priorities. In fact, over the past year, a few European governments have viewed banks as a source of fiscal financing for these priorities rather than as a key growth engine. For example, Italy, Spain, Hungary, the Czech Republic and Lithuania have proposed new banking taxes, although the European Central Bank has warned that “the level of the extraordinary tax may not be proportional to the longer-term viability of a loan.” Institution and its capital generating capacity”.
The fragmented and more limited nature of the European financial sector is just one factor contributing to the short-term performance of European equities. As has been shown in the past, despite this pressure, Europe can still experience months or even a few quarters of outperformance.
However, without a stronger financial heartbeat that can in turn contribute to stronger growth, achieving sustained European outperformance will continue to be much more difficult. There is plenty of research to support the World Bank's 2016 conclusion: “Countries with more developed financial systems tend to grow faster over long periods of time.”
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