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Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.
The writer is a former chief investment strategist at Bridgewater Associates
European equity markets are starting 2024 following a familiar pattern: underperforming US peers in local currency terms. Between 2009 and 2023, such underperformance resulted in cumulative S&P 500 gains that were five times those of Euro Stoxx 50.
Such US equity exceptionalism has not always been the case. In the two decades leading up to 2009, US and European equity returns were much more similar. Investors should look back to understand what changed this relationship and how those factors may evolve in the future.
By now it is well known that advances in technology and big US tech stocks were a key driver in the last decade’s outsized US market gains. Investors are also aware of several other factors weighing down relatively more on European economic and market performance. The list includes the Ukraine war, more limited post-pandemic stimulus, slowing trade with China, and going further back, the hit from the European debt crisis and a subsequent recovery constrained by a pact on national spending.
There is yet another structural cause of European underperformance that seems likely to persist: Europe’s financial sector. This is not about regional bank stock performance. Rather, Europe’s relatively narrow and fragmented financial industry is like a weak financial heart that struggles to pump sufficient capital and liquidity to support healthy European companies and economic growth.
The gap between US and European financial sectors has widened steadily since the 2008-2009 crisis, after which banking regulations were notably tightened. Indeed, the total market capitalisation of European banks (including the UK and Switzerland) fell from $2.7tn in 2007 to $1.4tn by 2021, according to a recent study by the Official Monetary and Financial Institutions Forum, a think-tank. Europe’s decline is even more striking when compared with the increase in US bank market capitalisation: from $1.6tn to $2.6tn. Asset management firms saw even greater divergence over the same period, with Europe’s asset management sector losing market share, partly to what is now a globally dominant US.
While size does not guarantee relatively stronger market returns or respective economic growth, it definitely helps firms more easily absorb costs tied to changing regulatory requirements and technology needs. The size and breadth of US financial firms also create a positive feedback loop with capital markets that support a more robust ecosystem over the business cycle. Larger, healthy banks can extend more credit, which supports companies and overall economic growth. That economic growth, in turn, creates a positive backdrop for households and businesses to invest, which both benefits the banks but also spurs development of capital markets and non-bank financial firms. Those non-bank options provide more choices of investment and financing — something particularly helpful when macro conditions or regulations lead banks to moderate lending temporarily, as was seen last year.
Tighter regulations after 2008 are far from alone in holding European finance back. Cultural and political issues have contributed as well. Despite successfully launching a single market and currency, European politicians have so far failed to transform a decade of discussions into effective banking and capital market unions.
Lack of agreement by policymakers has often stemmed from different voter priorities. Indeed, the past year or so has seen a handful of European governments look to banks as a source of fiscal funding for those priorities rather than a key growth driver. For example, Italy, Spain, Hungary, the Czech Republic and Lithuania have put forward new taxes on banks, despite a warning from the European Central Bank that “the amount of extraordinary tax might not be commensurate with the longer-term profitability of a credit institution and its capital generation capacity”.
The fragmented and more limited nature of Europe’s financial sector is only one input that contributes to the short-term performance of European equities. As has been seen historically, Europe can still have months or even a few quarters of outperformance despite this drag.
However, sustained European outperformance will continue to be much more difficult to achieve without a stronger financial heartbeat, which in turn can help create stronger growth. There is ample research to support what the World Bank concluded in 2016: “Countries with better-developed financial systems tend to grow faster over long periods of time.”
