Choose European Stocks Over the US

European stockmarkets, along with many of their global counterparts, have long been correlated with the US. Indeed, according to Merrill Lynch, 99% of the variation in monthly European stock prices has historically been down to the S&P 500 index, the dollar/euro exchange rate and the ten-year US Treasury bond yield. But this year, the main US indices have barely shifted, while the FTSE Eurofirst 300 index is 16% ahead.

So why have they diverged, and can Europe's out-performance endure? One reason is interest rates. In the US, rates have risen ten times since mid-2004 and further monetary tightening is on the cards, while the European rate environment has been more benign with no change in the price of money for two years.

The heavier weightings of resource stocks in European markets have also helped, and European companies are more exposed to the robust international economy and so less hampered by lacklustre consumption at home.

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Consumption may now improve as recent data for the eurozone have been positive, while the outlook for the US has clouded over thanks to high oil prices and hugely indebted consumers dearer oil has a larger impact on US consumers than European ones, Commerzbank's Joelle Anamootoo told Dave Shellock in the FT. Throw in mounting concern over house prices, and this explains why the risk appetite for US stocks has fallen, while that for European equities is rising.

Europe is also restructuring, with governments beginning to reform and companies slashing costs. And while there is still plenty of room for further efficiency gains, with US margins close to record highs, it's hard to get excited about the US earnings growth outlook. Another problem for the US in this context is the heavy weighting of the financial sector, which makes US earnings more vulnerable to interest rate hikes.

Valuations also bolster the case for Europe. While the US is on a 2005 p/e of 16, the Eurofirst 300 costs just 13.5 times earnings, while according to Morgan Stanley's figures, European valuations are still at a 28% discount to the US, compared to a historical average of 20%. All in all, Europe looks a better bet; Citigroup reckons that stocks should gain 8% to 10% over the next six months and 15% to 20% by the end of 2006.