Asset Allocation Bi-Weekly – From Magnificent 7 to European Revival (4/14/25)

The recent outperformance of European stocks has been noteworthy. Confluence Associate Market Strategist Thomas Wash joins Phil Adler to discuss why this may only be the beginning.

What is Confluence Podcasts?

Podcasts from Confluence Investment Management LLC, featuring the periodic Confluence of Ideas series, as well as two bi-weekly series: the Asset Allocation Bi-Weekly and the Bi-Weekly Geopolitical Report (new episodes posted on alternating Mondays).

Phil Adler: 00:00

The recent outperformance of European stocks has been noteworthy. Confluence Associate Market Strategist Thomas Wash joins us to discuss why this may only be the beginning. Thomas, we've discussed the appeal in prior discussions of European defense stocks. But just to be clear, we're focusing today on European stock markets as a whole. Correct?

Thomas Wash: 00:36

So first off, thank you for having me, Phil. Today's report examines the potential implications for European stock markets if a shift in the global financial system leads investors to move away from holding dollars. The key takeaway is that as global growth slows and alternatives to the dollars are sought, Europe could emerge as a viable option. However, for this shift to have lasting effects, structural changes in Europe would still be necessary, particularly in reducing bureaucratic obstacles and excessive regulation.

Phil Adler: 01:05

The recent outperformance by European stocks compared to US stocks comes after a long period of underperformance. Just how long before this recent surge have European stocks lagged?

Thomas Wash: 01:19

Phil, do you remember y two k? Because that was the last time European stock markets consistently outperformed their US counterparts, which was in the early two thousands. The shift was largely driven by the .com bubble bursting, which crushed US tech stocks while European markets were relatively tame. Yet the broader trend of US equities dominating European peers has persisted for nearly fifty years.

Phil Adler: 01:42

And what has been holding Europe back?

Thomas Wash: 01:46

One big reason is that European companies aren't as productive as American ones. Europe has many rules that make it hard for businesses to start up and grow big. Because of this, European companies stay smaller and focus on being stable rather than growing fast like many US companies do.

Phil Adler: 02:01

And let's review how have European stocks performed lately compared to US stocks.

Thomas Wash: 02:08

I believe the main driver behind this performance shift was changing investor sentiment about Europe's economic outlook. At the start of the year, many were optimistic that the war in Ukraine might end and oil prices could fall leading to greater regional stability and lower energy costs. Another key factor appears to be growing EU concerns that The US might reduce its security commitments to the region. This is supposed to block, especially Germany, to consider increasing their defense spending, which has benefited certain sectors and contributed to the market rebound. Thomas, is it possible to pinpoint the origin of this turnaround by European stock markets?

Thomas Wash: 02:48

The turnaround seemed to occur around the time of president Trump's inauguration as he openly expressed his willingness to push for a swift end to the Ukraine war. You see, this bolstered confidence that tensions in the region would eventually ease. Additionally, the momentum gained further steam when Europe began considering plans to create an EU wide budget to boost defense spending, a move that followed president Trump's criticisms of the bloc for failing to meet its NATO defense commitments.

Phil Adler: 03:14

Is it possible to view this as basically a a shift in investor preference from growth to value stocks prompted by trade tensions and the perception that US growth stocks were overvalued?

Thomas Wash: 03:28

Yeah. I see this trade mostly as a bet that US stocks, especially those magnificent seven tech darlings, have gotten way overheated after their two year run. Don't get me wrong. Investors piled into these companies thinking they'd rule the AI world, but now people are getting cold feet about how much cash they're burning. And things really started to wobble when the whole strong US growth story lost steam after the president ignited a trade war with US allies.

Phil Adler: 03:55

Before we get to the question of how long this might continue, what percentage of The US stock market is held by foreign governments and investors?

Thomas Wash: 04:05

According to the Tax Policy Center, foreign investors own more than 30% of US corporate equities, both direct and indirect holdings. What's particularly striking is that European investors dominate this foreign ownership with holdings exceeding $8,000,000,000,000, more than all other regions combined. The substantial European stake actually helped drive the recent rotation trade as many investors repatriated capital shifting market dynamics.

Phil Adler: 04:33

Do you expect that foreign investors' sentiment toward US stocks will decline sharply because of these trade and geopolitical tensions.

Thomas Wash: 04:43

For me, I'm less concerned about shifting sentiment toward US stocks and more worried about weakening confidence in the dollar. While equities have demonstrated extreme volatility, the dollar's recent decline following tariff announcements were particularly troubling. This reaction suggests markets may no longer view the currency as a reliable hedge against uncertainty. Should foreign investors lose faith in this dollar's safe haven status, we could see lasting consequences. Exchange rate volatility and potential depreciation might deter capital flows back to The US markets as currency risk could significantly erode portfolio returns of foreigners.

Phil Adler: 05:21

Thomas, if we can assume that these current tensions and trends will continue, do European stocks have plenty of room to grow?

Thomas Wash: 05:30

You know, look. Here's the deal. Europe's gonna get hammered by these US tariffs. No two ways about it. And let's be real.

Thomas Wash: 05:37

This pain isn't going away until those tariffs do. Why? Because Washington now sees any country running a trade surplus with America as cheating the system. So Europe's stuck between a rock and a hard place. Either get their consumer spending more or find new markets fast.

Thomas Wash: 05:52

Now, in theory, there's a way out. They could pull a Reagan and slash red tape across the block to spark innovation and productivity. Heck, if they really wanted to go big, they could even create some sort of fiscal union to make borrowing cheaper across the block just to create stimulus programs. You do that, and suddenly, Europe's the hottest investment destination on Earth. But let's not kid ourselves.

Thomas Wash: 06:14

Do I really think they'll do it? You know, I'll believe it when pigs fly. Though never say never. Right? Who knows?

Thomas Wash: 06:21

When their backs are against the wall, Europe may surprise us.

Phil Adler: 06:25

How about bonds? Are you anticipating that foreign investors will in fact turn away from US treasuries as the dollar declines?

Thomas Wash: 06:34

I do think that is a real risk. Without yield insensitive buyers supporting our bond markets, treasury yields could surge dramatically. Why? Because traditional investors won't accept artificially low returns, especially as The US keeps flooding the market with new debt issuance.

Phil Adler: 06:52

Where will these foreign investors go instead?

Thomas Wash: 06:57

Right now, foreign investors are kinda stuck. They might just stay on the sidelines or even pull some money back home while they figure out their next move. Honestly, nobody's really sure which country comes out ahead in all of this.

Phil Adler: 07:10

Is any reasonable trend already starting, or you can can you see signs of it?

Thomas Wash: 07:17

We've seen some folks dipping into the euro and yen as alternatives, but who knows if that'll last or if it's just a short term play while everything's so up in the air. And, hey, don't be surprised if gold and maybe even crypto starts looking real tempting soon.

Phil Adler: 07:34

How about US Investors who who may be attracted by the tilt toward value stocks in European markets? Is there a danger that this might accelerate a decline in US stock valuations?

Thomas Wash: 07:47

Right now, it's still too early to tell anything can happen. If sentiment shifts on US policy, we might see American investors bringing money back home, especially with more attractive valuations now. But first, they'll want some reassurance that the economy is on solid footing. That picture should start to clear up over the next few weeks as companies report earnings, and we have a better understanding of trade policy.

Phil Adler: 08:10

Wanted to ask a question about those US technology stocks which have been hit hard recently. This comes after the magnificent seven stocks rose almost 24% from September to December. We did discuss in January a growing investor trend to treat these stocks as a safe haven, and you did warn at that time that they could be at risk for a correction. Do you think that after the recent pullbacks in tech stocks that they now warrant legitimate appeal as a safe haven?

Thomas Wash: 08:42

I'm glad to talk about it because that call clearly did not age well, but I'm glad I at least flagged the downside risk. You know, right now, with US and global growth in question, I think hunting for value is a smarter move than piling into big tech. Sure. Things could shift over the next few months, but there's still too much uncertainty to dive headfirst into the market's growthier sectors.

Phil Adler: 09:06

And finally, how are confluence asset allocation models digesting all this volatility and adjusting to it? And what's your advice for investors?

Thomas Wash: 09:17

While we are monitoring all market developments closely, we remain focused on identifying promising opportunities both domestically and globally. To investors, we'd emphasize that maintaining flexibility will be essential for successfully managing through this period of uncertainty.

Phil Adler: 09:34

Thank you, Thomas. Our discussion today is based upon sources and data believed to be accurate and reliable. Opinions and forward looking statements expressed are subject to change without notice. Also, this information does not constitute a solicitation or an offer to buy or sell any security. Our audio engineer is Dane Stole.

Phil Adler: 09:52

I'm Phil Adler.