: The promise of European stocks gaining an edge over their US counterparts is fading after a brief spell of outperformance, as concerns of an economic slowdown weigh on the outlook for earnings.

Where Europe stood to gain from a shift away from big tech stocks, investors are instead turning to undervalued sectors of the US market. Their preference is driven by data showing the US economy’s resilience and expectations that the Federal Reserve would cut rates sooner and more aggressively than previously anticipated. 

On its own, the picture in Europe looks robust with the Stoxx 600 at a record high. Still, the gauge underperformed the S&P 500 in August. On an annual basis, too, the index has lagged by nearly 9 percentage points so far in 2024, a second straight year of underperformance.

“US stocks remain more attractive even at higher valuations as the earnings growth potential is also higher,” said Evgenia Molotova, a senior investment manager at Pictet Asset Management Ltd. Europe’s greater reliance on Chinese imports also puts it at a disadvantage in the event of a global recession, she said.

Global stocks are rebounding after concerns about a potential economic contraction in the US triggered a selloff in early August, with tech stocks particularly hard-hit as investors questioned whether valuations had outpaced the benefits of heavy spending on artificial intelligence.

European stocks initially appeared to be among the biggest beneficiaries of the shift away from tech after underwhelming quarterly reports by some members of the Magnificent Seven such as Amazon.com Inc. and Alphabet Inc. 

Buoyed by the European Central Bank’s first rate cut, a Bank of America Corp. survey in July showed that a net 60% of fund managers expected European stocks to gain over the medium term, before turning more pessimistic in August.

Investors increasingly turned to previously overlooked areas of the US market instead. The S&P 500 equal-weighted index - which reduces the dominance of tech mega-caps - outperformed the Nasdaq 100 for a second consecutive month in August, marking its longest streak of outperformance since the end of 2022.

Similarly, a brief period of optimism for European stocks was reflected in two weeks of $500 million in inflows after 13 consecutive weeks of outflows. However, the trend reversed with $800 million being redeemed in the seven-day period through Aug. 28, according to BofA strategists citing EPFR Global data.

Europe’s economic growth outlook is one of the biggest challenges. Germany’s gross domestic product contracted in the second quarter, with sentiment particularly downbeat in the key industrial sector. Additionally, an uneven recovery in China - a crucial market for European industries such as luxury goods and automakers - has weighed on earnings.

A Citigroup Inc. index shows that economic data across the euro area have been increasingly disappointing since June, in contrast to a recent pickup in the US.

“When you worry about growth, you go for the part of the market that provides growth,” said Beata Manthey, an equity strategist at Citigroup, who prefers US stocks. 

Manthey noted that she would need to see upgrades to corporate earnings estimates and reduced political uncertainty to become more optimistic about regional equities. Currently, data show analysts’ estimates for Stoxx 600 profits over a 12-month horizon have remained relatively flat since June, while S&P 500 forecasts continue to rise. 

Despite this, some investors see potential for European outperformance due to its continued valuation discount. The Stoxx 600 trades at about 14 times forward earnings, compared to 21 for the S&P 500, according to data compiled by Bloomberg.

“There are good reasons for saying the European performance should be less volatile and perhaps a bit stronger than the US because the starting point in valuations is very different,” said Guy Stear, head of developed markets strategy at the Amundi Investment Institute. 

However, Stear emphasized that sustained optimism on economic growth and corporate earnings into 2025 was needed to support continued investment in European equities.

“Is there a catalyst immediately tomorrow? Possibly not,” Stear said.

  - Bloomberg