A Tale of Two Economies

As the world continues its battle with coronavirus, equity market performance has been starkly different across the globe. Take a look at the US major equity indices – the S&P 500 and NASDAQ – versus the major indices for Europe. This is year-to-date performance for US stock indices and France (CAC 40), Italy (FTSE MIB), and the UK (FTSE 100):

The major US indices are up 7.4% (S&P 500) and 26.5% (NASDAQ), while the European indices are all down significantly for the year. What gives? Let’s walk through some important takeaways that have to do with key differences between the US and Europe.

Key Differences

The disparity mostly comes down to the types of companies that exist in the US versus Europe. The US is dominated by fast growing, innovative, and mostly technology-oriented companies. Indeed, the composition of the broad S&P 500 is nearly 30% technology companies (the NASDAQ even more so). Most of these fast growing companies are riding secular trends – that is, they are enjoying strong and sustainable demand from a longer-term shift in consumption preferences. Think Amazon with delivery services and Apple with digital devices, for example. When economic turmoil hits, the companies riding secular trends tend to be insulated as their innovative offerings remain in demand. And, specific to the coronavirus, technology-oriented companies have been big winners in helping people adapt to the stay-at-home environment. Companies that are innovating and growing help keep people employed, even in hard times.

In contrast, Europe is dominated by less-innovative, slower growing companies. The French CAC 40, for example, is largely dominated by retail and industrial companies . In the Italian FTSE MIB, financials are the biggest sector exposure, trailed closely by utilities. These types of companies experience greater pressure when crisis times hit, as they don’t receive the benefit of secular tailwinds with innovative products and services that consumers still highly demand. These types of companies, and their earnings, end up being very cyclical. When the economy goes through a rough cycle, these companies go through a rough cycle.

Which begs the question – where are all the growthy, innovative companies in Europe? Why are there no global technology companies being created in France? Italy? It’s an important question. Clearly, as we can see through the existing pandemic, innovative companies can provide a cushion through hard times by leaning on their secular growth. As a country, having companies that innovate and are growing is a legitimate hedge against economic cycles, helping secure the growth of a given country for the future. Any country should conceivably want to be home to innovative, growing companies. And yet, these companies remain predominantly in the US.

The biggest reason is simple – the capitalistic framework in the US provides the best incentive for these companies and workers to be here. This is increasingly salient as we head into an election where one party seeks to steer the country more toward socialism – potentially endangering the future growth prospects of the US. While things like increasingly taxing the wealthy, raising corporate taxes, and expanding worker unions may seem good to some, it would be wise to look to Europe to see the long-term ramifications of taking this less capitalistic path. Europe, with its more socialistic structure, has become dominated by slow growing, highly cyclical companies. Europe in turn has been in mostly a growth slump for ages, and is arguably more exposed to economic shocks. There are clear risks in taking the path toward socialism.

The US vs France

Let’s dig a bit deeper and do a quick comparison – the US versus France.

France, to support its expansive social programs, has some of the highest tax rates in the developed world. Granted, France’s social safety nets help keep their citizens somewhat insulated from economic shocks. But this comes at the high cost of disallowing people from truly growing their wealth, including reaping the rewards of hard work and taking risks on innovation.

In the US, the top marginal tax rate is 37%, which kicks in for income over about $500,000. In France, the top marginal tax rate is 45%, which hits any income over just $185,000! This is merely a fraction of the $500,000 threshold in the US. Moreover, France taxes all capital gains at 30%, and has an annual wealth tax of up to 1.5% on any existing wealth over about a million dollars. For a time, France even had a “supertax” of 75% on any income over a million dollars as well. (This “supertax” was scrapped as several of the wealthiest people in the country promptly abandoned their citizenship).

This high-tax, anti-capitalist framework prevents innovative, growing companies from being created in France. Why would someone risk capital and seek to create an innovative, growing company in France, when taxes would eat away virtually all of the potential earnings the person makes from that company? This leads innovators to the US, of course. And the future growth companies end up being born here.

Looking Ahead

While this certainly isn’t an exhaustive study on the different frameworks of the US versus Europe, the difference pointed out here is important. More important now than ever perhaps, as the path of the US may well be towards a more socialistic future. With the higher taxes required to support such an environment, the US may lose its growth and economic resilience borne from the innovative companies that thrive under a capitalistic structure. As a country, we would do well to remember the capitalist structure that has led us to maintain the lead as the global economic superpower for more than a century.