The European (non?) discount

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Good morning. Goldman Sachs has said it will wade deeper into private credit, the latest in a series of big banks and asset managers to do so. If there is a more crowded corner of the finance industry, we don’t know what it is. Is everyone in this mob going to be able to produce equity-like returns with bond-like risk? Colour us sceptical. Email us: [email protected] and [email protected]. 

European stocks, American revenues

Here’s a familiar chart:

That’s large-cap US stocks’ premium to large-cap European stocks, in price/earnings ratio terms. The premium is now vast by historical standards — 65 per cent! — and there is a lively debate about what to make of it. In one corner: quant/value investors arguing that mean reversion is on the way. In the other: American exceptionalists who see supercharged US growth and returns reaching all the way to the horizon.

We’ve already said our piece about this back-and-forth. But there is another way to think about the discount: might European stocks be a way to buy exposure to the US economy on the cheap?

It is often said that 40 per cent of S&P 500 sales are international (it is said so much, in fact, that I’ve never bothered to find out if it’s true). There is no equivalent figure for corporate Europe’s exposure to the States, so I whipped up my own estimate. S&P Capital IQ lists the US revenue exposure of many companies — indeed, it has this for 246 of the 350 members of the S&P Europe. Doing a little multiplication, one finds that those companies’ US revenues account for 22 per cent of the total revenues for that index. Using this as an estimate of total exposure assumes there are not big companies in the index with large unreported exposure to the US; my guess is that there aren’t.

This might seem like a decent argument for owning a European index: not only is it cheaper than US indices, but more than a fifth of it is the US. It’s not that simple, though: you are not getting bargain US exposure from the European index unless the companies within the index with lots of US exposure are trading at cheap prices. 

I’ve had an unscientific look at this, and the answer is maybe. Obviously one is not getting a bargain price on world-beating companies that happen to be domiciled in Europe. Novo Nordisk (revenue 55 per cent US), LVMH (25), SAP (32), ASML (11) and Hermes (19), the five largest companies in Europe by market cap, have an average forward P/E ratio of 34. That’s higher than Alphabet, Microsoft, Apple and Meta. We’re looking for something that flies a bit under the radar. 

If you look through the European index for companies that have meaningful US exposure, reasonable (mid-teens or below) P/E valuations, and decent historical growth, you might come up with a list like this (data from S&P CapitalIQ):

Many of these companies have rough US comparators, as indicated in the rightmost column (readers may be able to think of better comps). The pattern, looking across each pairs, is that the European comparator’s valuation appears, on first pass, quite a bit like the US one. Ashtead’s price/growth trade-off resembles United Rentals’, Ahold’s looks a lot like Kroger’s, and so on. It is not obvious that European companies’ US exposure represents a bargain. And, in general, making specific company-to-company comparisons makes the Europe discount seem a lot smaller. 

How scary is Wednesday’s CPI report?

We intimated yesterday that tomorrow’s CPI report is a particularly important one: with the bond market already rumbling in response to hot economic data, a tick upward in inflation would be wrenching, and a tick downward most welcome. 

Recently, of course, all CPI reports have seemed important, and in general the present always feels riskier and more uncertain than the past (Is there a name for this form of irrationality? There should be. How about “the Armstrong effect”?) As it turns out, though, there is in fact more worry about this report than other recent ones, by one measure. Here, from Garrett DeSimone at OptionMetrics, is the option-market implied move in the S&P 500 on Wednesday, compared with the last seven reports:

Fear of inflation is back. 

Calculating minimum liquidity

A handful of readers reached out with questions and comments on the number we gave for Fed liquidity in our letter last week. We used total reserves that the Fed holds on behalf of banks plus balances in the Fed’s reverse repo programme. Together, these two numbers give a representation of how much money is available to US banks and money funds at any given moment.

Finding the numbers is a bit confusing. There are a lot of Fed data series in Federal Reserve Economic Data (FRED). And, importantly, the Fed holds the reserves of other nations’ central banks and allows foreign banks to participate in the overnight reverse repo programme — those assets should not be included in a reading of US liquidity. The Fed’s H.4.1. table has the right numbers. Add “Reserve balances with Federal Reserve Banks” on the bottom, which does not include foreign holdings, and “Others” under “Reverse repurchase agreements”, which are the US funds in the RRP. The number we get is $3.48tn (FRED series here and here).

But there is a big caveat. We compared the current liquidity level, relative to GDP, with the level during the 2019 repo crisis, treating the 2019 level as dangerously low. But this is just a crude rule of thumb. In September 2024 there was a brief but unwelcome jump in the securities overnight financing rate (Sofr), or the rate at which banks lend to each other against their Treasury holdings. This hints that we might be closer to the minimum level of system liquidity, and therefore the end of quantitative tightening, than our rule of thumb would suggest. 

Again, ending QT will be “learning by doing”.

(Reiter)

One good read

Long live the king.