There is something of a great debate underway about the relative merits of European vs. US equities. The forward price-earnings ratio of Europe’s Stoxx 600 Index (SXXP) stands at 14.7 (based on Bloomberg’s bottom-up survey of equity analysts) vs. 17.8 for the S&P 500. That makes European stocks significantly cheaper, although a great deal of expected future earnings in Europe involves an heroic assumption about recovering bank earnings. European stocks have underperformed their American counterparts in nominal terms during the past year (up 3% vs a 17% gain in the US). The rise in the euro vs. the dollar, though, gave a slight advantage to European returns in US dollar terms (up 19%).
By one important gauge – the willingness of management to invest in their own businesses – Europe is lagging, however. Capital expenditures in the US have risen to well above their pre-crisis level, while CapEx in Europe remains well below previous peaks.
That’s not because European companies don’t have the funds to invest. On the contrary, the Free Cash Flow yield of the main European equity index stands at around 8%, much higher than the 4% Free Cash Flow yield of the S&P 500. European managers are building up cash balances rather than ploughing money back into their businesses.
European corporate leverage (measured by the ratio of net debt to earnings before interest, taxes, debt service and amortization, or EBITDA) has declined sharply since the crisis. Before 2008, European credit growth in the nonfinancial sector peaked at around 14% year-on-year. It remains flat now, as companies build up liquidity.
With loan growth close to zero, it’s hard to see how Europe’s banks can meet the aggressive profit targets offered by the equity analysts.