Institutional Advantages Driving U.S. Equity Premium

A dominant narrative attributes the U.S. equity premium to structural and institutional strengths that give American companies and capital markets a sustainable edge.

Innovation and Technology Leadership: The U.S. is home to the world’s technology giants — Apple, Microsoft, Amazon, Alphabet, and others — which dominate global market capitalization and innovation. These companies benefit from cutting-edge research and development, network effects, and scalable business models that translate into high profit margins and consistent earnings growth. This tech dominance attracts investor enthusiasm and supports elevated valuations.

Depth and Liquidity of Capital Markets: U.S. financial markets are among the largest and most liquid globally, offering a broad investor base, sophisticated market infrastructure, and efficient price discovery mechanisms. The well-developed venture capital and private equity ecosystems further foster innovation by enabling startups to access growth capital, fueling a vibrant IPO market and sustained public company success.

Corporate Governance and Regulatory Framework: The U.S. corporate governance environment provides relatively strong shareholder protections, transparency, and regulatory clarity. These features reduce informational asymmetry, enhance investor confidence, and facilitate capital formation.

Robust Domestic Consumer Market: The large, affluent American consumer base underpins stable revenue streams for many companies. High consumer spending power and a culture of innovation-driven entrepreneurship contribute to a favorable business environment.

Collectively, these factors build a compelling institutional foundation for U.S. equities, justifying a premium valuation and supporting their resilience through economic cycles.

Cyclical Timing and Economic Factors Impacting Valuations

Alternatively, some analysts argue the valuation gap largely reflects differences in the economic cycle phases and sector composition rather than permanent structural advantages.

Divergent Economic Growth Paths: The U.S. economy has generally exhibited stronger growth and more dynamic labor markets compared to the eurozone, which has faced sluggish productivity, demographic challenges, and political fragmentation. Stronger growth expectations in the U.S. translate to higher projected corporate earnings and, consequently, higher equity valuations.

Monetary Policy Divergence: The Federal Reserve has historically moved faster and more decisively in both hiking and cutting interest rates, directly impacting equity valuations by influencing discount rates and capital costs. The ECB has taken a more cautious and gradual approach, reflecting the heterogeneous economic conditions across member states, which in turn has influenced European equity performance.

Sectoral Composition Differences: European stock indices are heavily weighted toward cyclical sectors such as financials, energy, and industrials, which are more sensitive to economic slowdowns and commodity price swings. Conversely, the U.S. market is heavily weighted in growth and technology sectors, which tend to be less cyclical and more insulated from near-term economic fluctuations, attracting premium valuations especially in low-rate environments.

Currency Volatility and Exchange Rate Effects: Fluctuations between the U.S. dollar and euro can impact returns for global investors and corporate earnings when translated into home currencies, further contributing to valuation discrepancies.

Additional Considerations: Political and Fiscal Factors

Beyond pure economic and institutional factors, political stability and fiscal policies also play a role. The U.S. benefits from relatively stable federal governance and fiscal stimulus tools that can support growth during downturns. The European Union, with its complex multi-country governance and budgetary constraints, often faces challenges in enacting swift fiscal responses, which can weigh on investor sentiment.

Looking Ahead: Convergence or Continued Divergence?

Whether the valuation gap narrows depends on several key dynamics:

• Europe’s Structural Reforms: Continued progress on enhancing innovation ecosystems, corporate governance, and capital markets integration could help European equities command higher valuations.
• Economic Cycle Synchronization: Should Europe experience a stronger cyclical upswing while the U.S. slows, valuation multiples could converge.
• Global Monetary Policy: Coordinated easing or tightening by the Fed and ECB may also influence relative valuations by affecting risk sentiment and capital flows.
• Technological Catch-up: As European companies invest more heavily in digital transformation and sustainability, sectoral shifts could reduce the premium assigned to U.S. tech.

Conclusion

The divergence in valuations between U.S. and European equities is driven by a complex interplay of both enduring institutional advantages and cyclical timing differences. The U.S. market benefits from a superior innovation ecosystem, deeper capital markets, and stronger corporate governance that support premium valuations. However, economic growth patterns, monetary policy approaches, and sector compositions also significantly influence relative performance.

For investors, understanding these underlying factors is essential to navigate portfolio allocation decisions effectively. While the U.S. may continue to enjoy structural benefits supporting higher valuations, cyclical shifts and Europe’s reform momentum could create compelling opportunities to capitalize on valuation gaps. In a dynamic global environment, flexibility and a nuanced view of both structural and cyclical forces will be key to successful investing across these major equity markets.

A Rare Phenomenon in History
Since 2023, US stocks and gold have witnessed a synchronous and significant rally. As of October 29, 2024, both the S&P 500 and COMEX gold have risen by 52%. The simultaneous boom of a risky asset and a traditional safe – haven asset for nearly two years is a rather rare occurrence in history. By reviewing cases since 1968 where US stocks and gold have risen simultaneously for at least two years, we found only six instances: from 1970.5 – 1973.1, 1978.4 – 1980.9, 1985.2 – 1987.8, 2003.3 – 2007.10, 2009.3 – 2011.9, and 2016.2 – 2020.8. When categorizing the US economic state based on the year – on – year changes in US GDP and CPI, during the current rally of US stocks and gold, both GDP and CPI are declining in tandem, similar to the economic state during 1985.2 – 1987.8.

The Underlying Common Driver: Surging Liquidity

Liquidity as the Key Factor
The concurrent rise of US stocks, as risky assets, and gold, as a safe – haven asset, is primarily driven by liquidity. This liquidity doesn’t necessarily stem from the Federal Reserve’s rate cuts. For instance, during the US rate – hiking period from 2004 – 2006, both US stocks and gold still rose. When measuring dollar liquidity through the dollar index, during the past six periods of simultaneous rises in US stocks and gold, the dollar index declined, with an average drop of 15.9% and a median decline of 9.7%. Evidently, the common factor behind the simultaneous rise of US stocks and gold is a weak dollar rather than low interest rates. In 2023, gold prices significantly deviated from real interest rates but maintained a high negative correlation with the dollar index.

Reasons for Liquidity Loosening in 2023
In the 2023 stage of the Federal Reserve’s rate hikes and balance sheet reduction, why was there liquidity loosening? We identify two possible reasons. First, non – US central banks cut interest rates before the Federal Reserve, and the spillover effect of global liquidity boosted US stocks and gold. The current global rate – cutting wave differs from the past, with non – US central banks taking the lead in cutting rates while the Federal Reserve lagging. When measuring global liquidity by the proportion of net rate cuts by global central banks, the most strained moment of global liquidity had passed by early 2023, with liquidity marginally loosening, coinciding with the starting point of the rise in US stocks and gold. Additionally, the trend of Chinese treasury futures in the past two years has been largely in line with that of US stocks and gold, while US treasuries have somewhat decoupled from them. This might also be an indication of liquidity spillover, as a portion of the abundant domestic liquidity in China has flowed into overseas assets like US stocks and gold. Second, other channels in the US released liquidity to offset the Federal Reserve’s balance sheet reduction, resulting in substantial liquidity loosening. In 2023, during the Federal Reserve’s rate hikes and balance sheet reduction, based on the 2018 experience of similar actions, both US stocks and gold should have declined. However, asset prices exhibited a state of liquidity loosening in the high – interest – rate environment. Behind this divergence between liquidity quantity and price might be the release of liquidity from other US channels to offset the Federal Reserve’s balance sheet reduction. For example, the most discussed topic in the market is the decline in the scale of US reverse repurchase agreements, which has relatively released liquidity into the financial market to counteract the Federal Reserve’s balance sheet reduction. This can be seen from the trend of base money. The growth rate of US base money rose from a low of – 15.7% in December 2022 to 10.8% in February 2024. However, the growth rate of US base money has declined after February 2024, yet US stocks and gold continued to rise simultaneously, indicating that there are other domestic capital sources in the US driving liquidity. From the perspective of the US real estate market, with mortgage rates at 6% – 8%, a 15 – year high, housing prices still rose. Similar phenomena of divergence between liquidity quantity and price also occurred during the two periods of simultaneous rises in US stocks and gold in the 1970s. Moreover, the share of US dollars in global foreign exchange reserves, an indicator of the US dollar’s creditworthiness, has generally moved in tandem with the dollar index over the past 25 years. However, in the past three years, a significant divergence has emerged. The central value of the dollar index has risen to around 100, while the share of US dollars in global foreign exchange reserves has been declining. When comparing the trends of the share of US dollars in global foreign exchange reserves and gold prices, we can observe that they are largely in sync, suggesting that the dollar index in recent years doesn’t fully capture the weakening trend of the US dollar’s creditworthiness. The liquidity released by the US itself is more abundant than what interest rates and the dollar index imply. The simultaneous rise of US stocks and gold often accompanies a decline in potential labor productivity and an increase in the output gap. As the saying goes, “buy gold in troubled times.” Troubled times usually occur in the later stage when the technological dividend of the previous generation ends, with the global economic pie shrinking and conflicts more likely to intensify. Hence, the trend of gold prices is largely inversely related to the US potential labor productivity. The rise of US stocks depends on the medium – term economic cycle, that is, the increase in the output gap. Therefore, the simultaneous rise of US stocks and gold often coincides with a decline in potential labor productivity and an increase in the output gap. The current simultaneous rise of US stocks and gold since 2023 is a combination of declining labor productivity and an increasing output gap.

The End of the Simultaneous Rise: Outlook for 2025

Historical Patterns of the End of the Rally
Historically, the ways in which the simultaneous rise of US stocks and gold ended have varied. In three of the six instances, both declined simultaneously. In two cases, gold prices fell while US stocks rose, and in one case, gold prices rose while US stocks fell. So, when will the simultaneous rise of US stocks and gold end? There are three crucial observation variables. First, the end of the simultaneous rise of US stocks and gold often coincides with an inflection point in the US core CPI, which can be either a bottom or a top. Second, the downward trend of the dollar index reverses. The end of the simultaneous rise of US stocks and gold usually accompanies the dollar index changing from a downward trend to an upward or sideways movement. In short, the downward trend experiences a reversal. Third, the US potential labor productivity often bottoms out and rebounds.

The Outlook for 2025
Looking ahead, with the contraction of the US debt – issuing scale, the simultaneous rise of US stocks and gold may end in 2025. As previously mentioned, when considering the combined state of GDP and CPI, the current simultaneous rise of US stocks and gold is similar to that during 1985.2 – 1987.8, but the post – rally state will be different. From the perspective of dollar liquidity, based on the experience of liquidity spillover in the 1990s, the reversal of Japan’s liquidity spillover to the US occurred when the US economy was accelerating its weakening, as the relative advantage of the US economic fundamentals began to narrow significantly, reversing the core logic of liquidity spillover. US economic data has maintained resilience since 2023, while other economies have been relatively weak. However, the unemployment rate continued to rise in July this year, triggering Sam’s Rule. In September, the US fiscal deficit was at its lowest level in the past four years for the same period. The US Treasury’s latest projection shows that the net debt – issuing scale in the US in Q4 2024 is expected to drop to $546 billion, and in Q1 2025, it’s expected to be $823 billion. The fiscal expansion model in the US since 2023 is unsustainable. Therefore, the core factor that drove the rise of US stocks in the 1990s will no longer hold this time. The US economy and inflation this time rely on debt – issuance and money – injection. After losing fiscal support, we expect the US economy to accelerate its downward trend in 2025, with dollar liquidity reversing. The resonance – driven rally of US stocks and gold in the past two years, which was brought about by liquidity expansion, will reverse. We recommend observing the net issuance of US bonds and changes in the US job market for corresponding right – hand – side confirmation. Meanwhile, from the perspective of potential labor productivity, the CBO predicts that the US potential labor productivity will reach a low point in 2025. At that time, the simultaneous rise of US stocks and gold may also end. Combined with our judgment that the US fiscal expansion model is unsustainable, the US output gap will turn downward in 2025, ultimately leading to a possible resonance – based adjustment in US stocks and gold.

The Risk – Reward Dilemma
As the US election approaches, global investors are fixated on the intense race between Trump and Harris. Citi points out that the market has already partially priced in the possibility of Trump’s victory, which implies that the risk – reward ratio of related trades has deteriorated. Analyses reveal that investors usually obtain positive returns by making investment decisions in line with market trends after the election results are announced, especially in the S&P 500 index and the US dollar index. Citi maintains an overweight position in US stocks. Considering Trump’s diminishing odds and the potential over – pricing of the ‘Trump trade’, Citi believes it’s time to take profits on ‘Trump trade’ and closely monitor the movements of US stocks and the US dollar after the election.

Citi’s Research Findings
Earlier this week, Citi’s analyst team led by Dirk Willer released a research report stating that the market has partly accounted for the probability of Trump’s win, indicating that the risk – reward ratio of Trump – related trades has worsened. Hence, Citi suggests that investors should take profits on some Trump – oriented positions, especially those assets related to Trump’s policies and improvements in poll numbers. These assets have performed well since the last non – farm payroll report, but Citi believes that the current risk – reward is no longer attractive.

Citi’s Statement in the Report
The Trump trade was extremely strong in October, driven by favorable macro tailwinds. At this stage, the risk – reward has deteriorated. We continue to take profits and are now cashing in on our outperformance trade in financial stocks. Firstly, if Harris still wins, given that the polls are still quite close, the market might misprice the outcome. Secondly, considering the actions that have already occurred, the market may be over – priced. Thirdly, the market may also make misjudgments when predicting the policy actions Trump would take if re – elected. Reports show that, based on historical data and market behavior analysis, investors often achieve positive returns by making investment decisions according to market trends after the election results, especially in the S&P 500 index (SPX) and the US dollar index (DXY).

Citi’s Position on US Stocks
Citi maintains an overweight position in US stocks, especially against the backdrop of year – end seasonal factors and the triggering of value – at – risk pricing (VRP) signals. Citi believes that although the market may fluctuate due to tariff issues or rising interest rates, these risks have already been partially priced in by the market.

The Situation of US Bank Stocks
Citi specifically mentioned the long positions of US bank stocks relative to the equal – weighted S&P 500 index and believes that these positions should be closed. The core of this strategy was to expect US bank stocks to outperform the average of other stocks in the S&P 500 index and establish investment positions accordingly to obtain relative returns. The institution’s research department previously established a similar investment position, which has brought a 1.03% return to Citi’s global macro – strategy investment portfolio since October 10, 2024. However, now Citi believes that this position should be closed. The institution thinks that the possibility of Trump’s victory has been over – priced by the market, and the actual election result is still highly uncertain as the polls show a very close race. In this situation, Citi believes that the risk – reward ratio of continuing to hold this position is no longer appealing.

Focus on US Stocks and the US Dollar
Citi believes that although the market’s expectations of Trump’s victory have been partly reflected in stock prices, US stocks will still perform well before the end of the year. This optimistic expectation is based on two main arguments. First, the implementation of any tariff policy takes time, so it’s unlikely to have an immediate negative impact on the market. Second, even if Harris wins, as long as the Senate isn’t controlled simultaneously, the impact on the stock market will be limited because maintaining the status quo is positive for the US stock market. Although the market is worried that rising interest rates may pressure the stock market, Citi’s analysis shows that a sharp rise in interest rates isn’t necessarily bad for the stock market. In stress scenarios, even if the US 10 – year Treasury yield may rise by 30 – 40 basis points, historical data shows that this change has no obvious impact on the stock market and, in some cases, stock returns may be positive. Citi has found through VRP signals that the market may be tactically oversold, indicating that the market may have overreacted to the election uncertainty. They believe that although there is uncertainty in the market before the election, the market shows signs of “excessive fear” and may rebound when the election results are positive. Additionally, seasonal factors also support a market rebound before the end of the year, so Citi maintains an overweight position in US stocks.

The US Dollar’s Outlook
As for the US dollar, Citi believes that the US dollar against the yen will be more affected by the outcome of the US election rather than Japan’s election or the policy changes of the Bank of Japan.