The dirty little secret about European stocks

A surprising re-emergence of European political risk has crushed stocks on the continent.

Heading into this week, the benchmark Euro Stoxx 50 Index was down about 3% in the trailing three months, while the MSCI World Index of developed-market countries was up nearly 4% over the same period.

It’s reached the point where France — the largest equity market among European Union nations and the epicenter of the current drama — has a lower market capitalization than Nvidia.

But there may be a silver lining in this drubbing for European stock bulls. Or rather, for investors who might be considering becoming European stock bulls: that Europe’s pain seems to be one of the few reliable path’s to Europe’s gain.

Three stretches of sharp European stock outperformance come to mind over the past dozen years:

• Mid-2012: A reaction to European Central Bank President Mario Draghi’s pronouncement that he’d do “whatever it takes to preserve the euro” as sovereign debt crises raged. Not too long before this, European stocks lagged the MSCI World by nearly 10% over a three-month period.
  

• Late 2014-early 2015: In the run-up to the ECB’s quantitative easing program (which itself was a reaction to relatively sluggish economic activity). The euro was slammed during, falling more than 10% versus the US dollar. That takes some of the bloom off the rose.
  

• Late 2022-early 2023: Russia’s invasion of Ukraine caused energy price spikes that crippled European industry and raised concerns that governments would be able to secure the necessary supplies to keep their populace warm in the winter. These concerns turned out to be overblown and European stocks enjoyed a significant relief rally.

A resolution of the last time we had high political drama in French — the election that brought President Emmanuel Macro to power — also helped spur a little mini-boom for European bourses.

So Euro-centric carnage, and/or worries that some are on the way, seem to be a prerequisite for meaningful episodes of future outperformance. (That, or a US market bust like the end of the dot-com bubble.)

Why are European equities cursed with needing to be hated before they can be loved?

The reason, in my eyes, is pretty simple: Europe has had a lost generation for earnings growth. 12-month forward earnings per share estimates for the Euro Stoxx 50 are still below their 2008 peak. Meanwhile, the MSCI World’s forward 12-month EPS projection is 60% above its pre-GFC peak.

Most top-down macro managers look at a mix of valuation, macroeconomic, and technical (a mix of behavioral, positioning, and momentum) factors when determining where to put their money to work. Europe has virtually always had valuation in its favor (to little avail), but rarely macro. And the technicals really only seem become favorable when the region is so unloved that it won’t take much in the way of positive news to help. In other words, when it’s a contrarian bet.

It’s not clear (and really, a little doubtful) that the current bout of turmoil is on the same scale of what was facing Europe during the myriad sovereign debt crises of 2011-2012 or heading into the winter of 2022, despite the discordant price action between Europe and its developed-market peers as of late. But the drama may promise to deepen no matter who’s able to form a government after these elections.

While American markets had the day off on Wednesday, France and a handful of other countries in the region were chastised by the European Commission for running fiscal deficits that run afoul of EU rules.

“This might seem insignificant for markets given we already knew about the deficit issue and it was priced in,” writes Deutsche Bank macro strategist Jim Reid. “But it’s particularly important right now, because we’ve got the French parliamentary elections on June 30 and July 7, where both Marine Le Pen’s National Rally and the left-wing alliance have indicated that they’d take a more assertive stance against the EU, raising the risk of more clashes over the months ahead.”