It took years to draw investors back to European equities, but keeping them invested is now becoming a challenge. The conflict involving Iran has impacted the eurozone stock market far more severely than its U.S. counterpart. Since the outbreak of hostilities, the Euro Stoxx 50 index of eurozone blue-chip stocks has fallen more than 7%, compared to a decline of less than 4% for the S&P 500. Although European equities have still outperformed U.S. markets year-to-date, signs of a reversal in this trend are emerging. Concurrently, the valuation discount that European stocks previously enjoyed is rapidly disappearing. U.S. markets have themselves undergone significant valuation compression, narrowing the gap between the two regions. Since last October, the forward price-to-earnings ratio of the S&P 500 has dropped by approximately 15%, eroded by market concerns over the disruptive impact of artificial intelligence and potential overspending on the technology. Additionally, worries surrounding private credit have heavily impacted U.S. stocks, particularly within the software sector.
In contrast, the comparable metric for the Europe Stoxx 600 index has remained stable over the same period. Part of Europe's challenge lies in its earnings outlook. Previously, profit expectations were consistently revised upwards, driven by anticipations of expanded fiscal spending and low interest rate policies, but these drivers have now faded. The European economy and corporate earnings are highly sensitive to oil prices, and the era of accommodative monetary policy appears to be over. The European Central Bank's next move is likely an interest rate hike, potentially as early as this month. Markets have already priced in nearly three rate hikes for this year, and the energy shock has begun to feed into inflation data. A team of strategists led by Laurent Douillet stated, "European corporate profitability is unlikely to withstand an Iran-induced inflation shock as it did during the 2022 energy shock." They noted, "Slowing global nominal GDP growth—6.6% compared to 12.5% in 2022—has reduced pent-up demand. Softer labor markets and diminished fiscal support are weakening corporate pricing power, making it difficult to defend margins, especially with operating margins excluding financials and energy near a record 12.5%."
Their models project approximately 5% earnings per share growth for the Stoxx 600 in 2026, significantly lower than the 25.5% growth seen four years ago and the current market consensus of 10%. However, the strategists emphasized that it is premature to declare an earnings recession, noting that oil prices would need to remain above $100 per barrel for several consecutive months to trigger an economic contraction. Over recent months, earnings momentum has favored the U.S., with earnings revision indicators in positive territory. This stands in stark contrast to Europe, where the number of rating downgrades has exceeded upgrades. Although the U.S., being energy independent, should be less affected by oil supply disruptions than Europe, it faces its own set of issues. These may explain the recent valuation derating, including high exposure to the technology and software sectors, labor market tightness, and uncertainty regarding the path of interest rates, all of which are keeping some investors cautious.
A portfolio manager at Swisscanto, Stefano Zoffoli, commented, "The U.S. market is less affected by the Iran crisis, but the labor market—partly driven by AI—and the struggling private credit sector are facing headwinds." He maintains that U.S. stock valuations are still excessive. Currently, central banks may become the critical variable: if an escalation of the war pushes oil prices higher, U.S. Treasury yields could continue to rise, weighing on global equities. However, a sharp spike in oil prices could also trigger market expectations of a recession, which might, in turn, signal interest rate cuts. In either scenario, the monetary policy outlook appears more favorable for the U.S. Daniel Morris, Chief Market Strategist at BNP Paribas Asset Management, said, "If negotiations to end the conflict succeed, interest rate cuts could stimulate a market rally. We believe the Fed's relatively patient stance regarding the inflationary impact of rising oil prices, compared to the more reactive European Central Bank, will provide further support for U.S. equities."
Recent price action indicates that confidence in European markets remains weak. The Stoxx 600 index erased all the valuation expansion accumulated between last October and February of this year within just one month. Meanwhile, Germany's DAX index has borne the brunt of profit-taking during the conflict, falling more than 8% since the war began.
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