European Equities Could Finally Surprise in 2023

It’s still early in 2023, but through January and a couple of trading days into February, something unusual is happening in equity markets: European stocks are outperforming the S&P 500 and by a wide margin at that.

As of Feb. 2, the S&P 500 is up 9% since the start of the year, but the S&P Europe 350 Index and the MSCI EMU Index are higher by 10.9% and 14.6%, respectively. Advisors know this is unusual because it’s been years since European stocks materially outperformed domestic fare and even longer since that happened for an extend period of time.

That is to say European stocks still have plenty to prove, but there’s no denying that January is a solid starting point. As advisors well know, European equities have been a frustrating proposition for the better part of a decade.

However, this year could be different and European stocks, broadly speaking, are inexpensive, as is often the case, and the group is showing overt signs of life. Let’s dig into some potential tailwinds for the asset class.

Really Cheap and That Could Finally Be a Good Thing

Advisors are right to be apprehensive about low valuations being a selling point on European stocks and the related funds because that’s been the case for some time. Additionally, there’s specter of geopolitical conflict in the region – namely Russia’s ongoing war against Ukraine, which is serving to further depress valuations on European stocks.

“If investors thought European stocks were cheap before the Russia-Ukraine war, the STOXX Europe Total Market Index now trades at a nearly 30% discount compared to the S&P 500 Index on a 12-month forward P/E basis,” notes Michael Arone, chief investment strategist at State Street Global Advisors (SSGA). “This has created a compelling valuation opportunity in an unloved asset with a lot of bad news already priced in for European stocks. For example, investors can purchase European stocks at a sizable discount compared to US stocks but with comparable EPS growth expectations over the next three to five years.”

Further supporting the case for European stocks are dividends – both in growth and yield terms. For example, the dividend yield on the STOXX Europe Total Market Index is roughly twice the comparable metric on the S&P 500. Plus, earnings growth is proving surprising stout in Europe, indicating the cash flow is there to support dividend growth.

“Perhaps the biggest surprise for European stocks is that despite recession fears, revenues, earnings, and profit margins have remained resilient. So, while US corporate profitability has slowed dramatically, European fundamentals have held firm. China’s re-opening from the pandemic also brings back Europe’s biggest customer. This makes the notable discount in valuations all the more interesting for investors,” adds Arone.

Weaker Dollar Could Support European Stocks

As advisors well know, the dollar was the best-performing major currency last year, but it doesn’t need to enter a full-fledged bear market this year to help European stocks.

Bottom line: Add up the aforementioned catalysts and the stage could be set for European equities to pleasantly surprise clients this year.

“Let’s face it, European stocks have been cheap for a decade but with solid fundamentals and a weakening US dollar as catalysts, the widening valuation gap is too big to ignore. The STOXX Europe Total Market Index has massively underperformed the S&P 500 Index over the last 3-, 5- and 10-year annualized periods through December 31, 2022. That performance gap could narrow this year,” concludes Arone.

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