European stocks? Undervalued according to Saxo Bank

Better-than-expected growth forecasts coupled with the impetus from the reopening of the Chinese economy, as well as below-average valuations, are the reasons why European stocks outperform their US counterparts this year. The risk of an escalating war or an uneven recovery in China has not gone away, but it could provide attractive buying opportunities given the structural advantage of greater exposure to fixed assets in European indices. Progressive deglobalization and higher interest rates for a longer period of time only tip the scales in favor of high-value European stocks compared to their growing counterparts overseas.

After a good run earlier this year, US stock indices are again in a technical downtrend. Also from a fundamental point of view, the arguments for further interest rate hikes are getting stronger, and US equities are likely to remain under pressure from higher yields. In addition, a theme that is leading the way in QXNUMX earnings and is likely to continue to weigh on US equities is margin compression.

We often emphasize the importance of a balanced portfolio and the advantages of including commodities in your portfolio as a hedge against inflation. In addition, this year is also associated with the possibility of diversification by spreading investments into different geographic regions. While S & P500 index has gone up by ~4% since the beginning of the year, MSCI Europe recorded an increase of ~9%. Much of this growth is due to the strong performance of French CAC 40 index, which went up ~13% year-on-day, while Euro Stoxx 50 index increased by ~12%.

Improvement of macroeconomic foundations

After the Old Continent survived the energy crisis without major losses last year, the leading indicators for Europe have been steadily strengthening since the beginning of this year. Flash indicators released this week PMI S&P for February showed that the PMI for the services sector in the region is rising again; production is also improving. Sentiment indicators also remain positive, with natural gas prices down more than 60% from their December high and more than 80% from their August high, easing pressure on corporate costs. In addition, Europe is better placed to benefit from the positive effects of the reopening of the Chinese economy than the United States, due to closer trade relations. Overall, the European economy appears to be relatively more resilient compared to 2022, when the recession was factored into valuations.

Potential profit increase

Cost pressures eased by falling energy prices enabled European companies to deliver better-than-expected earnings in the fourth quarter. Banks also posted strong performances, with luxury brands returning to the game with the expected recovery in demand in China. As of February 23, companies listed on the Euro Stoxx 600 index in the fourth quarter achieved earnings growth of 8,5%; by comparison, S&P 500 earnings fell 1,4% last quarter.

An improved Chinese demand forecast and a reduction in energy prices contribute to a further improvement in profit forecasts. At the same time, it is envisaged that European Central Bank will continue to raise rates, but the highest level is 3,5% compared to 5-5,50% in the US. Still, the potential for an upward correction of the Fed's path is greater than in the case of the ECB, suggesting a relatively smaller negative impact on the valuation of European equities.

Value against growth

The better performance of European stocks compared to US stocks is also driven by the better outlook for value stocks such as financials and commodities in the current high inflation environment compared to US tech-dominated indices. This marks the beginning of the reversal of the trend initiated after the global financial crisis, in which US indices based on growth companies performed better.

The greater share of material sectors in the European economy gives it a structural advantage over the US, as higher interest rates require more productive investment. The pandemic and the war also exposed supply-side weaknesses, initiating a cycle of capital outlays geared towards growing the real economy. This means that investments in the material economy will grow to ensure resilient supply chains, energy and food security, and a strong infrastructure and defense cycle. The emergence of these types of trends will mean new ratings for European stocks.

Attractive pricing

Despite the recent increase in European indices, valuations still seem attractive. The leading price/earnings ratio of the Euro Stoxx 600 index is now 13,5x, compared to a ten-year average of 14,4x. The European index is also at a discount to the S&P 500, whose leading P/E is currently at 18,1x. The difference in valuation can be partly explained by differences in the sectoral distribution – the US index contains more tech stocks and fewer value stocks in industries such as materials, industrials and finance. However, even with sector-adjusted weightings, European stocks are still cheaper than their US counterparts. The dividend yield for the European index, currently at 3,6%, is also more favorable than for the S&P index (1,7%). Due to the significant outflow of investments from European markets last year, caused by concerns about energy shortages and possible recession, many investors remain wary of European equities, so there is still room for catching up.

Risk in the future

The key risk for European equities could be the next escalation of energy problems due to the escalation war in Ukraine. An uneven recovery in China could also make Europe's growth outlook more moderate in the future. The weakness of the EUR, which could be accelerated by extremely aggressive Federal Reserve policy or even a surge in fears of a global recession, triggering an influx of safe investments in the US dollar, could worsen the returns on European assets.

Market implications

Given the factors above, broad exposure to European indices or listed funds with downside protection looks appealing. Due to the fact that more and more investors are considering diversification and moving away from exposure to US equities only, the difference in the valuation of European indices in relation to their American counterparts may decrease. Should risks escalate in the near term, this could mean even more attractive buying opportunities in European stocks, positioning you well to strengthen the physical world at the expense of the intangibles. Everything from German industrial enterprises po French luxury brands – remains attractive given the immediate benefits of reopening the Chinese economy to the world.  European stocks z defense industry also constitute an important safeguard against the rapidly progressing deglobalisation, however semiconductors and energy are subject to extensive investment in line with current political priorities.

About the Author

Charu Chanana, market strategist in the Singapore branch Saxo Bank. She has over 10 years of experience in financial markets, most recently as Lead Asia Economist in Continuum Economics, where she dealt with macroeconomic analysis of Asian emerging countries, with a focus on India and Southeast Asia. She is adept at analyzing and monitoring the impact of domestic and external macroeconomic shocks on the region. She is cited frequently in newspaper articles and appears regularly on CNBC, Bloomberg TV, Channel News Asia, and Singapore's business radio channels.