US stocks outperforming Europe but probably not for long

US earnings per share are around 60 to 70 per cent above the earnings peak in 2007, while European earnings are some 30 per cent below the peak in 2007, says analyst

A broker at the stock exchange in Frankfurt, central Germany. European stocks are underperforming compared to US firms. /Daniel Roland/AP

US corporate profit growth is outpacing European profit growth at the fastest pace on record, but the anomaly is unlikely to last.

The drivers of that divergence, such as the US tax cuts, a weak dollar, and disparity between share buybacks on either side of the Atlantic are fading, and some could even reverse in the second half of the year.

Certainly, the earnings gap now is remarkable. Based on comparative 12-month forward earnings per share, it's never been wider.

"We've never seen such a big gap. US and European earnings have always correlated, so this is a huge anomaly," said Martin Skanberg, a European equity portfolio manager at Schroders.

"The gap will close."

Mr Skanberg estimates that US earnings per share are around 60 to 70 per cent above the earnings peak in 2007, while European earnings are some 30 per cent below the peak in 2007.

Just under half the companies in the MSCI EMU (European) index have reported first-quarter (Q1) results so far, and profits are up just 0.2 per cent on the same period last year.

Around 80 per cent of the firms listed on the US S&P 500 have reported Q1 results, and earnings growth is running at 26 per cent.

Charlie Bilello at Pensions Partners reckons US earnings are growing even faster, at a 30 per cent rate. That's the fastest pace of year on year growth in more than seven years.

Yet Q1 this year will be the peak for US earnings growth.

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The rise in US Treasury yields to multi-year highs is altering the so-called equity risk premium, essentially the extra yield investors are paid to buy relatively risky equities over safer fixed income.

With 10-year US Treasury yields on the rise and now offering investors a pretty juicy 3 per cent, the US equity risk premium is under pressure.

It's a different story in the euro zone - bond yields are considerably lower, meaning equities offer a far more attractive return. Assuming all else unchanged, equity risk premia suggest European stocks are more appealing than US equities.

Of course, everything else never does remain the same, and one of the most important variables for international money managers is the euro/dollar exchange rate.

Last year, the dollar fell 12 per cent against the euro, its worst year since 2003. This boosted the dollar value of US profits accrued overseas, and at the same time had the opposite impact on European firms' profitability.

The dollar now appears to be in the early stages of a reversal, rebounding 4 per cent in the last three weeks to its highest since January. Wall Street is feeling the pinch, slipping nearly 4 per cent over the last three weeks.

If the dollar continues to drift higher and the euro lower, the impact on relative profitability should continue to favour Europe over Wall Street.

Another area where the European market could be poised to follow the US lead is share buybacks. Since 2010, S&P 500 companies have spent nearly $4 trillion on share buybacks, according to S&P Dow Jones Indices.

This has had a huge impact on Wall Street. And with Apple leading the way with its $23.5 billion buyback in Q1 and targeting up to $100bn in future repurchases, 2018 is on track to be another record year.

But Europe could finally be about to play catch up.

Mr Skanberg estimates European firms are sitting on over $1 trillion in cash. Much of that is in negative-yielding, short-term debt that could be used for investing, M&A, or share buybacks, he argues.