Financial markets provide an anecdotal narrative on the evolution of economies through time. Indeed, financial indices serve a dual purpose – the first one is that of providing a measure of overall market performance, and secondly, they serve to provide a look through into underlying market dynamics.

Specifically, equity indices are composed of a number of companies so that their individual performance is aggregated into an index performance. Modern finance sought to solve previous index shortcomings by ensuring that weightings are based on the company’s total equity value, known also as the market capitalisation. The delta on the market cap is the result of the change in the company’s equity performance which is attributed to sector performance. This marks a central observation for investors and economists alike, as it helps them to understand how economic sectors evolved in the past and what markets will shape the future.

A current look into European equity indices, such as the broad Eurostoxx index shows that the financial sector tops the spot with a weighting of 17 per cent. The three other dominant sectors are Industrials (16 per cent), Consumer Discretionary (13 per cent) and Information Technology (10 per cent). A decade ago, European Banks dominated other industries in Europe with 18 per cent of the market. This meant that the financial sector (that is, including the insurance industry) had a weighting of 25 per cent back in 2009.

This observation is a centre piece in understanding the economic fundamentals that underpinned European economies. Over the 10-year period, investors know that the economic weakness that characterised the European region for the following decade resulted in rates hovering at rock bottom levels. Intuitively, the compressed yield curves meant that banks could not borrow short and lend long at high margins. This has impacted industry profitability which compounded problems for the European region given the dependence on such industry. 

The subsequent fall in profitability shaved off economic growth prospects for Europe as bank equity values descended on the basis of weak profitability. This has redimensioned the banking industry as it lost 50 per cent of its weighting from the initial 18 per cent to nine per cent currently. Naturally, European economies evolved over the period and capital market’s theory paved the way to revitalise other industries. In fact, industries that gained prominence over the period were Technology, Industrials and Healthcare. In a way, the crippling financial situation in Europe served as a blessing as it reconfigured the industry structure holding up European economies, and mitigated the historic overdependence of the banking industry, resulting in improved economic resilience. 

Comparatively, Europe’s transatlantic partner, the US, is on a different footing. The industries that underpin the US economy have historically been broad and not overly dependent on a particular sector. However, over the past decade, investors could observe the rise of big tech in the US which dominated equity returns. This meant that the information technology overpowered other industries with the current weighting in the S&P 500 index standing at 23 per cent. The regional differences in industry weighting between the US and Europe explain most of the outperformance of the US economy when compared to Europe. Suffice to say, the world of technology provided the innovation that led to new products, processes and efficiencies that were unthinkable in the past. The dominant US tech players led the US economy to maintain its economic status and domination over other developed nations, including Europe. 

The under investment in the technology sector in Europe over the years made the region lag the US and other regions. In May 2019, Ernst & Young published a study entitled How can Europe sustain its digital drive? which shows that in Europe, London is the city that offers the best chance (fourth globally behind San Francisco, Shanghai and Beijing) of producing the next technology giant when compared to European peers, with Berlin and Paris ranking seventh and 12th globally respectively. In this regard, Europe must ensure that it has policies in place to bridge the skills gap in the tech field that will promote capital to flow into this key industry. Accordingly, this will create a sense of technological vibrancy that will enable top European cities to compete with global peers.

This article was issued by Jesmar Halliday, investment manager at Calamatta Cuschieri. For more information visit www.cc.com.mt. The information, view and opinions provided in this article are being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice.