U.S. Vs. European Stocks: Assessing The Relative Contributions To Earnings Growth

by: Evariste Lefeuvre

In many counties, the debate is still open on whether GDP growth will be driven by domestic factors and/or pulled by a recovery in global trade. Here I assess the contributions of domestic and external drivers of Earnings per Share (EPS) in both the US and the Eurozone (I take 12-month forward earnings, whose forecasts are highly dependent on the current situation).

For each economic area I estimate the sensitivity of the year-over-year (yoy) growth rate of EPS to the following factors: global trade, the capacity utilization rate, the nominal effective (trade weighted) exchange rate and the slope of the yield curve (10/2 year). Results are summarized in the table below.

There are some striking differences between the US and European EPS growth profiles:

I. US EPS are much less sensitive to an overall appreciation of the USD than EUR EPS are to a stronger Euro. The appreciation of the Euro weighs negatively on European EPS growth. On the contrary, US EPS are much less sensitive to the FX conversion factor: it might be due to the relative weight of the domestic market and also to the fact that many of the profits realized outside of the country are not converted into dollars and remain offshore. It could also be linked to the fact that the selling prices of product and services sold abroad are invoiced in dollars, providing a "natural" hedge to US businesses.

II. EPS of European stocks are much more sensitive to the evolution of global trade than those of the US index.

III. In both cases yet, domestic factors have the same influence (same elasticity): a higher capacity utilization rate drives operating margins upward.

IV. Lastly, the slope of the yield curve does not impact EPS growth the same way. A steeper yield curve is positive for EPS growth in the US while the opposite is true in the Eurozone. There is no "Great Recession" or QE effect here, as an estimate during the 2002/2008 period comes along with the same opposite signs on both sides of the Atlantic. It might be linked to the lower sensitivity of European banks' results to the slope of the yield curve than in the US.

Given the robustness of the results, I assess whether the current growth rates of EPS are consistent with my fair value models. As can be seen below, US EPS growth stands close to the lower band, which means that stronger EPS growth would not be at odds with the current level and position of the macro data.

Source: Datastream, Eviews

On the contrary, the growth rate of European EPS is close to the upper bound of the model, suggesting that the upward potential is clearly limited.

Source: Datastream, Eviews

This analysis suggests that European forward EPS have much less upward potential than their US counterparts - reducing the apparent edge of the European stock index over US in terms of expected relative returns.

This is confirmed by the EPS projections provided by the models. Using my forecasts for global trade, capacity utilization rates, foreign exchange trends and yield curves, I find that the potential for higher EPS in the year ahead is clearly stronger in the US...

Source: Datastream, Eviews

... than in Europe

Source: Datastream, Eviews

A weak recovery in global trade is detrimental to European stocks, a headwind that will not be completely offset by a slightly lower exchange rate for the euro. The steepening of the yield curve on both sides of the Atlantic will play at the advantage of US equity markets while I expect a slightly more pronounced rise in the capacity utilization rate in the US.

Bottom Line: US and European EPS growth rates differ significantly in their relative sensitivity to domestic and external factors. In addition US EPS growth is relatively muted in comparison to what my fair value model would suggest. On the contrary, the expected growth for European EPS is slightly above fair value: the odds are clearly in favor of US stock markets in terms of EPS forward-based relative value analysis.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.