• Valuation/sentiment reset make the case for overweight to the Eurozone markets

• Even on a sector-neutral valuation approach, European stocks are cheap vs the US

• Bearish risks include wavering earnings revision momentum, an uncomfortably hot inflation surprise gauge, and of course geopolitics

European equities had one of their best days since May 2020 on Friday. The region surged 3% as global stock markets recovered from sharp losses earlier in the week. At the morning lows on Thursday, Vanguard FTSE Europe ETF (VGK) was a smidgen above $60 - it closed the week near $64. For perspective, its 52-week high is just under $71. Was the washout, caused by fear related to the Russia/Ukraine conflict, good enough to mark an end to VGK’s 15% correction? Let’s dive into what’s going on with European stocks.

The featured chart below illustrates the breakout and retest of the Euro Stoxx 50 – the key regional benchmark stock index. While we still favor EU equities, we reduce our conviction.

Featured Chart: Euro Stoxx 50 Breakout & Retest

Reducing Bullish Conviction

The region has some bullish compelling features, but there are important risks that have emerged. Thus, we are reducing our bullish stance conviction. But we still favor the space vs more expensive (and underperforming) US stocks. YTD, Europe is down 6.5% while Vanguard Total Stock Market ETF (VTI) is off by 8.3%. A bright spot in Europe this year has been the UK, which is up more than 3%.

Warning Signals

Checking under the hood, sentiment has soured as the European VIX has soared. High yield credit spreads have also pushed higher – a significant red flag for the bulls. The “VSTOXX” volatility index climbed above 40 last week as the major European bourses endured severe losses Thursday. Geopolitical risks give a boost to the BAML Europe HY spread index.

Cheap Valuations

Some good news for the bulls is on the valuation front. The MSCI EMU forward PE ratio has dropped materially since 2020. The recent 13% pullback in the index has certainly helped to reset things. Earnings have been on the mend, too. On an absolute basis, Eurozone valuations are quite reasonable vs the long-term average while the area remains relatively cheap vs the US with a forward PE near 15.

A Sector Neutral Approach & the ERP

Neutralizing sector differences is important with valuation work. Indeed, even after factoring in the differences in complexion, European stocks trade at a whopping 40% discount vs US equities. The Eurozone’s equity risk premium (ERP) – a valuation measure comparing stocks to bonds – is higher than that of the US. On the absolute valuation chart, the EU ERP is also at the bottom end of the range since 2008. So, there’s clear relative value ongoing.

Weakening Earnings Revisions and Hot Inflation

Here’s the “but.” Eurozone earnings revisions momentum and the inflation nominal surprise index paint a somewhat bleak picture. Not to mention all the current unresolved geopolitical risks. Bear in mind that monetary stimulus support is almost certainly off the table as inflation runs way too hot in the region.

Our flagship Weekly Macro Themes report also investigates what’s happening with the EURUSD and the US Dollar itself. Currency analysis is crucial when allocating abroad.

Bottom Line:

We reiterate our bullish stance on European stocks but reduce our conviction. We assert that the Euro Stoxx 50 pullback off its Q4 2021 high helped reset valuations to compelling levels. Unfortunately, bearish earnings revisions and upside inflation surprises, not to mention the threat of war in eastern Europe, cast some bearish clouds for the group of stocks.