Staying the course

European equities have exhibited a rally that might make new investing seem unwise, but the region’s fundamentals suggest it has plenty of room to run.

The eurozone has been a case of promise low, deliver high in the last few months. Despite the hawkish policy of the European Central Bank (ECB), it seems the economy is going to dodge a recession that many once assumed was unavoidable. The unexpectedly warmer winter has been a boon the region desperately needed, reducing energy and natural gas prices. You make your own luck, though. Credit countries and citizens with increasing storage and reducing use. As long as Russia presses on with its invasion of Ukraine, energy levels will remain uncertain, but the risk has been reduced in the near term.

The recent slide in gas prices have played an oversized role in the recent decline in headline inflation, which has declined from its peak in October. Core inflation continues to inch up, but we think it also will fall under the brunt of the large ECB rate hikes. A half-point increase last week brought the base rate to 2.5% in only half-a-year, yet the region’s GDP grew in the fourth quarter and the International Monetary Fund forecasts 0.7% growth in 2023. That’s modest, to be sure, but is not a contraction. Earlier concerns of a recession have faded and the odds of a soft landing have risen, boosting business/consumer sentiment, according to the European Commission.

The counter argument might seem to be Germany, whose economy did shrink in the fourth quarter. But we think it stands to benefit considerably from another positive factor for the eurozone: the reopening of China. While many European countries are geared toward China, Germany is particularly tied to it because of its vast industrial sector. As the largest economy in the eurozone, this development should boost the region.

After many quarters of unrelenting strength, the U.S. dollar has finally declined versus the significantly undervalued euro. It began in the last months of 2022, and we think interest-rate differentials are declining, and other fundamental and technical factors point to a period of dollar weakness. This should benefit U.S. investors in Europe, a positive for the economy as a whole.

The road forward isn’t without potential bumps. Any escalation in the Russian aggression could dampen confidence, stall progress and cap stock sentiment. The resilient labor market—the unemployment rate is at multi-decade lows—might prompt more ECB hikes than the expected additional total of 1%. Also, equity markets seem to have gotten slightly ahead of themselves. We anticipated its present levels wouldn’t be reached until later this year. But that could be because they have priced in the ECB hikes and recession risk.

It is important to keep in mind that Europe is weighted toward value companies at a time when value have been outperforming growth. With the economy indicators skewing positive, it could continue to be attractive.