by Joe Herrle, CFA
Vice President Alternative Assets
Something is happening that hasn’t occurred in a very long time – international stocks are outperforming the U.S. markets. This shift marks a significant departure from the long-standing dominance of U.S. equities, which have historically been driven by robust earnings growth and technological innovation. The divergence started early in February, and, as of this writing, the global stock market index (excluding the U.S.), has returned 8.6% year to date, while the S&P 500 is down 3.7%. This is notable since over the last decade, the U.S. has more than doubled international returns, producing a cumulative gain of 220% vs. 97% for international stocks.
The reason for the long-term outperformance of stocks can be easily explained with one word: earnings. From 2018 to 2024, the S&P 500 earnings growth outpaced international growth by 7.6% annually (on average). If we unannualized that figure, we can really see just how significant it is: over that time period, U.S. companies grew earnings by 67% more than international companies.
Before we uncover why international is now outperforming, we must examine why the rest of the world has underperformed. The largest allocation in the international stock market is to Europe and the UK, which have largely lacked technological innovation. The U.S. is leading the charge in cutting-edge technology, and our stock market has benefited. These innovations have driven not only tremendous earnings growth from the tech giants but also productivity gains that benefit the economy as a whole.
As for Europe, you might wonder, where is their equivalent of Apple, Google, or Nvidia? The answer lies in regulations. The EU has set in place regulations aimed at protecting consumers, but in doing so they have made it difficult for innovative start-ups to form. As such, this has caused investors to be hesitant to allocate dollars to new and emerging technologies. Case in point.
This has become such an issue that the European Commission introduced a strategic framework this year called the Competitiveness Compass, which aims to promote the development and adoption of new technologies and align regulations with these goals over the next five years. This, along with the framework’s other goals of energy security and aligning climate goals with economic growth, in part increases the hope that Europe can return to growth. But, it is all about execution, and implementation has yet to be seen. Like our managing director, Steve Holwerda, always says, “A good plan well executed is better than the perfect plan not executed at all.”
The Competitiveness Compass is reflective of a current trend in Europe of rethinking the role of government, economic security and defense independence. One of the main drivers of the European stock market growth has been Germany’s recently passed spending legislation. Germany, Europe’s largest economy, just lifted its annual borrowing limit from 0.35% to 1% of GDP in order to increase defense spending and invest in critical infrastructure to stimulate growth. This marks a historic departure from decades of fiscal conservatism and is expected to provide a major stimulus to Europe’s largest economy. Consequently, German stocks have risen over 19% this year.
Still, it has yet to be seen if this shift in approach can provide a durable growth recovery for the region. Making structural reforms can take a lot of time to implement and even longer to see results. Economists seem to agree, as the forecasted GDP growth rate for the U.S. is estimated to roughly double that of Europe over the next two years.
Client portfolios have now seen underweight international stocks for several years. Until we see indications of accelerating earnings growth internationally compared to the U.S., we will remain underweight.
Takeaways for the Week
The Federal Reserve kept its forecast for two interest rate reductions this year, but raised inflation projections and lowered economic growth expectations.
The S&P 500 briefly fell into correction territory, defined as a 10% drop from recent highs, joining the Nasdaq, which was already in correction.