Episode 105: Europe front and center—is capital beginning to flow overseas?

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Kevin Headland

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The great rotation –  when US equities have outperformed their international counterparts for longer periods of time. Headlines in the financial media are often dominated by that term. Rarely do markets work like that. They don't move only because one has underperformed relative to the other. Rather, investors seek out better fundamentals and better valuation. So far this year, European equities have far outperformed their US peers. Is this the time the great rotation works? Is it a reversion to the mean or perhaps is the money simply following the better near term opportunity? Regardless of why? The key question will be whether the outperformance can continue. On this episode, we talk about what has driven the performance of European inequities so far this year and our views of the opportunity going forward. Listen on this is Investments unplugged. Welcome back to Investments Unplugged. I'm your co-host Kevin Headland, co-chief investment strategist at Manaf Investment Management. And with me as always is my other co-host, the Marco Nia. Marco. And welcome. Hey Kevin, how are you? I'm good, thanks. Happy pie day.

Macan Nia

I heard that dropping off the girls today and apparently pie in this context is the number, the math number, 3.14, all those numbers afterwards, it's such a not followed day that they've actually tried to replace it with actual dessert pies. I thought that was funny. But anyways,

Kevin Headland

Yeah, of course we're recording on March 14th, three 14 and that's why it's called PI Day. But yes, most people don't know it. My son actually asked me how many decimal places I can name PI after the 3.14. I used to know a lot, but that was in my younger days when actually it was funny. But now it's just like I'd rather have actual food pie than worry about one four, number eight. But I digressing, we got more things and better things to talk about. Today we're going to talk about the resurgence in European equities, what's been happening, why has, have they outperformed the US equities? But more importantly is this the time, is this the start of the great rotation that many pundits have been talking about, perhaps for at least a year or so, whenever the US equity market tends to outperform European equities the following year, leading into the year, there's a lot of narrative that this is the time we need to rotate into European equities or outside of us. So that's what we're going to talk about today. A couple of different things we're seeing out there is defense spending, infrastructure spending in Europe and Germany, some of the improvement of manufacturing, but we're going to get into that right now. So what are the first things that we're seeing in terms of the reasons we think that some of the outperformance of Europe, but most recently?

Macan Nia

Yeah, I think our colleagues have done a lot of on it. We're going to speak to that, but there's a couple of main big ones. So number one is the re-arming or potential re-arming of Europe as a result of what's happening across Atlantic between the Trump administration and nato. German election results number two has given optimism to the area central bank policy being the third. And then two other ones we're manufacturing, let's not get ahead of ourselves. It's improving from a weak base, but it is improving. And then last but not least, this flows, but let's start off with that re-arming plan and let's not get into the details. It's very well documented, but essentially the Europeans have agreed to really spending 650 billion euros on defense spending across the majority of their countries. And to put that into context, Kev, the Americans over really the past, since inception of the war, have given the Ukrainians roughly 70 billion.

And that speaks volumes of how big a package of 650 is to put the 70 billion in context to Kev from the Americans, the Europeans. So when you include Germany, uk, Denmark, Holland, Sweden, France, Poland, those are the big contributors that only amounts to 52 billion. So it's unreal. So that's where the Trump administration has grown frustrated and people will say, okay, well great defense spending. That only goes to certain companies, but think about the infrastructure needed to support a military, whether it's logistics, transportation, food, housing. It's not just the guns and the artillery. It's everything that goes along with the war machine. And that historically has been stimulative.

Kevin Headland

I think it's also a switch materially from this notion of austerity measures going back to the European crisis where the European countries were saying, no, we're going to decrease our spending. That was the way to get out of our debt cycle. And there's this narrative unfortunately that I think a lot of times you can't grow unless you spend, there's this kind of nice balance between growth and spending and you want to spend for an economy. So it's accretive to economic growth. If you don't spend, how are you going to grow? And I think that was a lot of the view of perhaps many international or global investors and saying, do we want to invest in areas of the world that are not really growing? Normally companies earnings growth are synonymous with economic growth. So if your economy's not growing, you're not spending your economy, why should your countries grow their earnings as well? So that's been problematic. Again, going back to the European financial crisis,

Macan Nia

And that's another reason is this German election result and ultimately what they've agreed to, listen, as long as we've been in the business, we can always view the Germans as being fiscally and saying it nicely, fiscally responsible with their money. That's what you call me Kev. I

Kevin Headland

Going to say they're like you. They're exactly I,

Macan Nia

I'm not cheap, but I'm fiscally responsible. But with the new election, the Germans have recognized that they need to spend more to grow their economy. The German economy, along with the European economy has faced challenges over the past couple of years. So there's a, there's hopes that this $500 billion Euro package is going to be approved and to compare. The Germans don't spend relative to even the Europeans in a sense that the German government basically expenditures of the percent of their GDP is 2.8% and the Euro zone is 3.3%. And like you alluded to, investors are excited about the fact that there's going to be fiscal stimulus in the broader Euro zone and as a result, the general economy is going to improve and as a result, corporate earnings are going to improve moving forward. It kind of maybe going against what's happening in the US with investors cautious or concerned about fiscal spending with Doge and having the opposite impact.

Kevin Headland

It's interesting that Germany's debt to GDP has not grown since 2007.

Macan Nia

Say that again. Their debt to GDP

Kevin Headland

Debt to G has not grown.

Macan Nia

Oh wow.

Kevin Headland

Instead seven, where'd you think about United States? I've grown there over a hundred percent of debt. GP Canada is over 80% of debt. GP Europe has kind of been stagnated in this like 70% level for quite some time. And again, go back to 2007. So they have been very, very careful about their spending and not only is 500 billion Euro package, they're looking to spend over trillion euros over the coming decade in both infrastructure and event spending. And I think the key was the infrastructure spending. That was the key to bring this minority government to coalition and agree on the spending because I think they realized that we need to put money into the economy and they've been, again, under those asteria measure for quite some time. And again, as we said, when you spend on the economy or as you spend, I say from a government perspective, fiscally you tend to get some economic growth.

There is a fine balance, but when you haven't spent for quite some time and you have this pent up need, these numbers come out really, really extremely large. But if you actually extrapolate them over time, they're not as big as perhaps one would think. And also because they haven't spent that. GDP is still very tangible, kind of like Canada for a while prior to the financial crisis and prior to Covid, our debt GP was actually very low. We had the room to increase our spending, so we're still below a hundred percent debt. GP and Europe, especially Germany had the room to grow as well.

Macan Nia

It's really interesting to see this type of mentality as a result of the European financial crisis. So they went through that back in 2011 and they've been pretty austere since then. And now they're being forced because they're recognizing they need not only fiscal stimulus but monetary stimulus. And that's the third reason that the Euro zone, I don't think this is one of the stronger ones because it seems like generally central banks have been in a more easing mentality over the past couple of weeks compared to how we started the beginning of the year. But ECB cut rates recently, they're at two and a half. They've cut 150 beeps in the past nine months. Interesting enough though. I think it's March 14th yesterday, right? Was the Bank of Canada cutting by 25 beeps? Was it two days ago or Yes.

Kevin Headland

No, the 12th. Yeah.

Macan Nia

Yeah. Two days ago, sorry, it was on the road in Quebec, but so you're seeing it in Canada, interesting enough again where there was one cut priced in for the Fed at the beginning of this year. Now it's probably closer to three, but this is another reason you have fiscal stimulus and monetary stimulus supporting the potential for reliable and European

Kevin Headland

Growth. I think that's a key as well. As you said, I think it's a combination. You need to have both those measures going in the same direction. And I think it's not necessarily, it's the direction, it's also that it's the move, the change. I think the unexpected part was the fiscal spending. We're starting to see some unwind of the tightening of the monetary policy despite still some economic challenges and some inflation issues in that area of the world. The central banks are realizing that perhaps right now it makes more sense to support the economic narrative versus trying to fight this little bit of stickier inflation. It's not elevate inflation, but stickier inflation. And I think you're seeing central banks realize that it's more important to protect the growth side right now than try and fight that inflation.

Macan Nia

Yeah. Sorry, go ahead Ken. Sorry. No, go ahead. No, I'm going to the fourth reason again. Yeah, sorry. I was going. Yeah. So revival of manufacturing now I find it humorous how some believe that there's a resurgence in European manufacturing. I think that's a strong word, resurgence. It's coming off a very, very terrible base. And when you look at it from a PMI manufacturing perspective, but that being said, the Euro Eurozone manufacturing, German manufacturing hasn't been this strong over the past couple of years. When you look at French and Italian manufacturing, it's improving at the margin. And again, going back to if there's tangible fiscal stimulus supportive monetary policy that the path of least resistance for this area is likely upwards.

Kevin Headland

Yeah, it's so important when you look at manufacturing in the Eurozone in European countries have been in that red level for quite some time. And just for a quick explanation of the manufacturing purchasing managers index both on the manufacturer side and the services, it's a monthly survey of manufacturers for the manufacturing index and of course services companies. For the service index, they ask 10 questions trying to really determine are the companies in expansion or contraction? If the number comes out above 50, the companies are coming in expansionary territory, below 50 contractionary territory at fifties. You're essentially your neutral, your zero line. And when we look across the Eurozone, especially in Germany, they've been in the low forties for quite some time and we used to have this kind of broad measurement that 45 is kind of recessionary. Anything at that level is kind of really weak, really low.

And you get this level where it's almost, it's as bad as it's going to get. And it seems like we were hitting that in the low forties for Germany in the Eurozone, and now we're starting some improvements there. And perhaps we're seeing that as that tailwind, that less bad is good. And I think that's one of the keys you're seeing right now is because at least some of the base is improving, yes, off of weak numbers, but directionally again, everything seems to be moving in the right direction. You have improvement in manufacturing, improvement in services, inflation coming down, fiscal stimulus and monetary policy, reducing. Those are rising tides that pins will raise the boats. And I think that's, that whole idea of it coming together is where you're seeing this narrative perhaps of European equities doing better because of that's been doing worse. And that's key. They've underperformed for so long. Now it's time perhaps that it moves higher because the improvements in the underlying data is also doing well

Macan Nia

And it's bitter. You've seen it in the index numbers. So as you mentioned, Kevin, March 14th is when we're recording this, I look across European indices. You have the German DAX up 15%, the Spanish IEX is up 12, the fusi one hundreds up. Actually the UK is not that it's trailing down, but the, it's up 6%. France is up nine. And when you cross the Atlantic s and p down four and a half, NASDAQ down nine TSX down one. And as a result, we know what happens with performance, whether it is indices, mutual funds, stocks, people chase performance. And we have seen that with flows out of the US going into Europe. And I heard this once, and as I find it very clever that water and fun flows are very similar. They always follow the path of least resistance. I like that. Yeah, I heard it years ago. I don't know where, but I found it very clever and it's true. And I highlighted those performance numbers. So when you compare the MSCI Europe versus the s and p 500 year to date performance in the past 25 years, it's never been this strong of an outperformance. And we've seen flows follow that performance where in February it was the largest inflows into European equities over the last five years. Now, let's put this into context too, is over the last five years too, $18 trillion has flowed into the US equity markets.

Kevin Headland

Unreal.

Macan Nia

62 trillion is the market cap roughly, depending on which indices you include, but it shows you the, okay, let's not get ahead of ourselves. It's been three, three and a half months. The question we're receiving, and sorry, before I go to that point, I think it's expectations too, Kev. It's always about expectations and to start the year. So Goldman Sachs has this major conference at the beginning of the year, it's the Goldman Sachs Global Strategy Conference, and they did a survey of all the PMs there and 60% of those not advisors, their PMs thought that the US was going to be the best and only 8% thought Europe. So we always talk about valuations and expectations, things being priced for perfection, and we're seeing it unfold today where this sentiment was so negative on Europe. Any change to that narrative in a positive perspective has a lot of tailwinds and you're seeing the opposite of that happening in the us. So we get to question, okay, is this going to continue? Should we get into European equities now? What are our thoughts?

Kevin Headland

Yeah, just going back really quickly to that narrative, is that change? You said the numbers and I'm just looking at the Canadian dollar currency value. So for Canadian investors right now the SB 500 is down roughly four and a half percent of Canadian dollar terms. And the DAX is up over 21%. That is a massive differential in two and a half months. And as you said, the key there is that US equity market was priced for perfection. We were saying that anything that doesn't meet or exceed, and I already put the emphasis on exceed expectations, is at risk of causing some volatility or challenging environments for US equity securities. And you got multiple cracks, shall we say. One, you had earnings for many companies that were maybe not as good as some investors wanted. You had the on, again, often tariff discussion, some of the headline risk, perhaps weaker economic growth, the change perhaps in the narrative of US exceptionalism where they were the only one in the world that was going to be growing from an economic perspective and market perspective.

And then you had the other side where things were getting better for the us. So you had this combination of more negative headlines or less positive on the US side and more positive side are less negative on the European side. And this kind of confluence of events puts this change in momentum. And as you mentioned, huge valuation differential. Everyone said Europe is cheap relative to the us and it was from a historical measurement. European stocks from a trailing price earnings ratio perspective were cheaper than both their own history. So looking at the MSI Europe, it was cheaper than its own history over the last 20 years. And on a relative basis, whether you're looking at both the s SP 500 mark cap weighted or the s SP 500 equal weighted index, they were cheaper. Interestingly enough, now that valu wage gap has completely disappeared, the European Index, MSI Europe is actually in line with long-term average and also in line with its average in terms of the EIT index. And we look at the mark cap weighted index rate pretty much in line as well, slightly cheaper, but definitely not an obvious valuation cap that we had coming into the year.

Macan Nia

And I think too, it's the passport. So historically, one of our colleagues, Erica Camilleri did some excellent research on s and p 500 versus MSCI Europe. And her work suggests is when there's this historically, when there's this type of outperformance, it's unlikely to continue moving forward. And often investors who are chasing returns are ended up disappointed with a new dollar invested in Europe today. And not to make it simplistic, but it's a question of tech versus financials. So a big driver of European performance has been the weight of their financials and our financials have done well. Makes sense. Everything we've talked about is if there's a, you don't even have to go into cheaper money, stronger growth, stronger profits, stronger consumer spending, good bank profits, and those financials are bigger weight of the European forces than here. And whereas here it's, when I say here, I mean s and p 500, not TSX, but it's technology.

So what's your view of those going forward? Is European financials likely to continue outperforming or tech that has got clobbered? Will they at some point this year maybe not get their complete golden charm back or a back but not have this Debbie Downer cloud? That seems to be over the sector right now. And I think again, as investors, time and time again is don't count things out. Now everyone wants to rush to Europe, but again, advisors are asking about China, why? Because China's up 20% year to date. And then we remind investors is why don't you have a Chinese dedicated material Chinese equity sleeve because it's an extremely volatile ride. So I think for us, I think there's select opportunities within the Euro zone. I know our portfolio managers are finding individual securities that look interesting, but just investing in the MSCI Europe because of performance, despite all of these positive aspects, how much of that has already been priced in? So to get that next oomph or next move upwards, you need this times two again or something to that effect. And I just don't see it on the horizon. So I would be wary in terms of allocating new dollars into Europe expecting the same type of return,

Kevin Headland

Well, it's always the case and you always need that next catalyst to drive things forward and higher. And in the SB 500 and the nasdaq, it has been the material consistent growth from earnings perspective for these mad cat names, the Magnuson seven. And in Europe, what's the next catalyst to drive it higher if we believe it's not a matter of either or rotate from us to international or European inequities, it's a matter of being diversified and then it goes back, it just proves it. Yes, you had US equities outperforming and some believe that you said Goldman Sachs, that us would continue to outperform and maybe the majority if not a lot of our portfolios should be invested in the US because oh, we don't like Europe or it hasn't done really well. It's so underperformed and ignoring it and it just shows you time after time, things do move and you have some reversion of the mean, you have some out performance.

And we've been saying it's not about investing in Europe per se, it's investing in certain companies and some companies in Europe have nothing to do with the European economic environment. One of our colleagues, Matt Miskin says, and I love this line, I told him I was going to steal it because he says, we don't invest in countries, we invest in companies. I think that's great. And I said it before, it's not about where I should be invested, but what I should be invested in. And we're seeing that and it's at a good global equity portfolio that is well diversified. The portfolio managers have a bigger sandbox to play in better opportunities to choose the companies. It just makes sense when we're looking at a portfolio to be diversified and we should be chasing returns because normally the last one's in the last one's out. And unfortunately that tends to be a negative impact to overall performance from an invest perspective. And it is not positive for achieving the long-term goals when you're chasing performance.

Macan Nia

Yeah, and you mentioned that, and I think I talked about it on the last podcast recording where in Canada is a perfect example of that. Canada faces a lot of challenges from an economic perspective, whether it's manufacturing services, Kev, I was at the airport and you can see into customs, I thought this was really interesting. It's our march break here in Ontario and there's no one in customs going to the states. Now we can debate why that is. Maybe some of that is patriotism. Sure. I think a lot of it has to do with the currency, how expensive it is to go to the US as Canadians. But there's an aspect of it where I think it's from an economic perspective, even airlines in the US are seeing a decrease in bookings. The reason I'm bringing that up is last year, Canada economic perspective, very challenging.

TSX was up 18%. So we are not investing in countries now. What the country is doing can help, but each index is also very nuanced compared to their economy. And I think that's very important as we navigate this uncertain time with everything that is going on. I was joking with advisor yesterday, it's kind of like I was in Scotland a couple years ago and Scottish weather is very unpredictable. It seems very quickly, and the Scotts have this thing is if you don't like the weather, just wait five minutes. And I think you were saying they have that in Calgary too, and remind clients that if you don't like the news flow on any given day, just wait five minutes because it seems to be changing on a daily basis.

Kevin Headland

I think that's one of the challenging issues right now. It's interesting, I was talking to a buddy of mine last night. He was a financial advisor and talking how much he's dealing with client calls and questions and uncertainty because of so much focus on the us. And of course as Canadians, there's a focus on our local headlines with tariffs, especially in the uncertainty of economic news and inflation. But it just shows you that there are opportunities elsewhere in the world. If you look around the world, you could find opportunities. This is not overly negative. We're in a global recession. This is not destructive short term as we say. It's disruptive, but there's opportunities and we have to be aware of that. And I think that's why it makes sense to have a balanced approach to investing and understanding what you're trying to achieve here. And I keep saying it in your words, spring trading and baseball, and when markets are growing well, you're on a hot streak. It seems like I'm just going to keep swinging to the fences and trying to hit home runs. And the more and more you try and swing for fences, the less likely you're going to hit home runs. And I think it's important now. Just be in the game. Don't be on the sidelines, hit those singles and doubles that money ball reference, just get on the base and eventually score runs. You win the game. I think that's key right now. What we're seeing in this environment,

Macan Nia

And I think I'll leave it off with my last thought with this, Kev, is be ready. I think likely the path of least resistance as of now is still the trend is likely to be lower, but we're getting to points now. I know from the peak where as well outside of today, we were s and p 10% correction territory. These are the opportunities that come around every couple of years and it's very important for investors to do a couple things, not sell into the weakness, more important to take advantage of that. So getting yourself ready, making that list, and then getting ready to act quickly because markets can turn very quickly as we all know.

Kevin Headland

And that's the key I think Mark, and you say this all the time, is investors often get paralyzed with fear and they can't make a move. And if you're feeling queasy and don't want to invest and push that button, that's probably the best time. I think it's important to remind those in the call advisors on investors post on LinkedIn right now that corrections are normal since 1980, going back to 1980, including 2024. The average pull down at any given calendar year is 14%. We should expect pull downs on every calendar year, but roughly 78% of the time, the calendar year performance for SB 500 is positive despite some of those pullbacks. So Europe is doing well, we shouldn't be chasing that. US not so well. We shouldn't be leaving necessarily. We shouldn't be running for the hills. It's all about managing portfolios, making sure well diversified.

Sometimes when things are going great in one area, we get overconfident and we shouldn't lose sight of our long-term goals and make sure we're already diversified and kind of don't chase the hot stocks, but don't just get overly fearful when things don't go right either. So that's our views right now. Don't chase Europe, but also don't ignore it either because I think there's still a lot of opportunities we a global equity portfolio. Perfect. Great. Awesome. Well, that's another edition of Investors Unplugged Mock. As always. It's been a lot of fun. And for those listening, thank you so much. If you enjoy the podcast, please rate us on whatever system you're listening to and please share this with other like-minded individuals. We're always looking to grow our readership and we really appreciate you listening. Invest Unplugged. I'm Kevin Headland.

Macan Nia

And I'm Mark Nia.

Kevin Headland

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