What Doesn't Matter for Investing in Europe
After making a fortune buying in the financial panic that followed Napoleon’s defeat at Waterloo, Baron Rothschild is reputed to have remarked “the time to buy is when there’s blood in the streets.”
Today, there is no blood in the streets. Europe’s disputes are resolved in boardrooms in Brussels rather than fields in Flanders. But the high politics of the European Union and the troubles of its flagship Euro currency have left many investors hesitant to invest capital in European equities.
In fact, some investors are already rushing for the exit. Europe’s equities have seen 25 straight weeks of fund outflows in 2018, making Europe the only region to record meaningful outflows this year.
Figure 1: European Equity Fund Flows
Sources: EPFR and Barclays Research as of August 2018
However, these fears of instability in the EU seem to share an implicit assumption: that membership in the European Union and adoption of the Euro currency are good for a country’s equity market. Over the past six decades, academics have identified numerous factors that explain equity returns, concluding that stocks usually outperform bonds (equity premium), that small stocks tend to outperform large stocks (size premium), and that value stocks tend to outperform growth stocks (value premium). But notably absent from this list is a country’s membership in a political union or adoption of a single currency.
We decided to test this assumption and look at how membership in the European Union—and adoption of the Euro currency—has impacted equity returns.
The European Union was formally established when the Maastricht Treaty came into effect in November 1993. Our analysis draws on Fama/French market return data which begins in June 1994 and spans the 24 years through December 2017. We sorted 19 European counties into two portfolios. The first portfolio contains EU members, and the second portfolio contains non-EU countries in Europe. The portfolios were rebalanced monthly to account for changes in EU membership throughout the 24 years. Within each portfolio, returns were weighted according to the GDP of each country (as a proxy for market capitalization) in order to place more weight on larger markets.
Figure 2 presents the results. Between 1994 and 2017, EU members delivered a market return of 8.4% per year versus 9.8% per year among non-EU countries.
Figure 2: EU Membership Effect (June 1994 to December 2017)
Sources: Ken French data library, MSCI, and Verdad analysis
It is apparent from Figure 2 that there is no evidence of a positive return premium for EU membership given the lower return we observe for EU members relative to non-EU members. But before we rush to conclude that EU membership is somehow harmful for equity returns, it is worth noting that the t-statistic of the return difference between EU members and non-EU members is 0.62, well below the minimum threshold for statistical significance of 2. Therefore, the return difference is indistinguishable from zero.
What about the Euro currency? Some EU members like Denmark and Sweden chose to keep their own currency, and other EU members like the Czech Republic, Poland, and Hungary will only be allowed to adopt the Euro currency in the future after meeting certain criteria. Within the EU, we compared the returns of these non-Euro countries to countries that adopted the Euro as their currency.
The chart below presents the results.
Figure 3: Euro Currency Effect (June 1994 to December 2017)
Sources: Ken French data library, MSCI, and Verdad analysis
Euro adopters have delivered a market return of 8.1% per year since 1994 versus 9.4% per year among countries with different currencies. The return difference of -1.3% per year (-0.06% per month) is indistinguishable from zero, with a t-statistic of 0.45.
Joining the EU and adopting the Euro currency—far from having been great boons to equity markets—were in both cases irrelevant for equity returns. The implicit assumption that membership in the EU and adoption of the Euro are somehow positive for equity returns seems unfounded.
What does matter for equity returns? Within the universe of European small-cap companies, there is a robust premium for investing in cheap (value) stocks relative to expensive (growth) stocks. Over the past 28 years, this small value premium has been 6% per year, as shown in Figure 4.
Figure 4: Small Value Premium in Europe (July 1990 to June 2018)
Sources: Ken French data library, MSCI, and Verdad analysis
The 6% difference between the annualized returns of small value stocks and small growth stocks equates to a monthly difference of 0.45%. This return difference has a t-statistic higher than 3—well above the minimum threshold of 2—so we can conclude that the small value premium in Europe is reliably different from zero.
The evidence suggests that investors should spend less time thinking about political unions and single currencies and more time focused on finding cheap equities. Value is predictive of returns in a way that geopolitics is not.