European stocks fall amid geopolitical concerns: next steps
European stocks had one of their best days since May 2020 on Friday. The region jumped 3% as global stock markets recovered from steep losses earlier in the week. At the Thursday morning low, Vanguard FTSE Europe ETF (VGK) was a little above $60 – it closed the week near $64. For perspective, its 52-week high is just under $71. Was the washout, caused by the fear linked to the Russian-Ukrainian conflict, enough to mark the end of the 15% correction of VGK? Let’s dive into what’s happening with European stocks.
The chart shown below illustrates the breakout and retest of the Euro Stoxx 50 – the main regional benchmark stock index. Although we still favor EU stocks, we are reducing our conviction.
Chart shown: breakout and retest of the Euro Stoxx 50
Reduce bullish conviction
The region has compelling bullish characteristics, but significant risks have emerged. Thus, we reduce our bullish position conviction. But we still favor space over more expensive (and underperforming) US equities. Year-to-date, Europe is down 6.5% while the Vanguard Total Stock Market (VTI) ETF is down 8.3%. A bright spot in Europe this year was the UK, which grew by more than 3%.
Checking under the hood, sentiment deteriorated as the European VIX soared. High yield credit spreads also pushed higher – a major red flag for bulls. The “VSTOXX” volatility index soared above 40 last week as major European exchanges suffered heavy losses on Thursday. Geopolitical risks are boosting the BAML Europe HY spread index.
Good news for the bulls is on the valuation front. The MSCI EMU forward PE ratio has fallen significantly since 2020. The index’s recent 13% pullback has certainly helped reset things. Earnings have also been on the mend. On an absolute basis, eurozone valuations are quite reasonable relative to the long-term average, while the zone remains relatively cheap relative to the US with a forward PE close to 15.
A sector-neutral approach and ERP
Neutralizing sectoral differences is important in valuation work. Indeed, even after accounting for differences in skin tone, European stocks are trading at a whopping 40% discount to US stocks. The eurozone’s equity risk premium (ERP) – a valuation measure comparing stocks to bonds – is higher than that of the United States. On the absolute valuation chart, the EU ERP has also been at the low end of the range since 2008. So there is a clear relative value going on.
Weakening earnings revisions and high inflation
Here is the “but”. The dynamics of Eurozone earnings revisions and the headline inflation surprise index paint a somewhat gloomy picture. Not to mention all the current unresolved geopolitical risks. Keep in mind that monetary stimulus support is almost certainly irrelevant because inflation it is much too hot in the region.
Our flagship Weekly Macro Themes report also looks at what’s happening with the EURUSD and the US Dollar itself. Currency analysis is crucial when allocating overseas.
Conclusion: We reiterate our bullish stance on European equities, but reduce our conviction. We say the Euro Stoxx 50’s pullback from its fourth quarter 2021 high has helped bring valuations back to attractive levels. Unfortunately, earnings downgrades and upside inflation surprises, not to mention the threat of war in Eastern Europe, cast bearish clouds for the stock group.