WSJ - Markets

A Stock Market Where the Rally is Actually Deserved

Patience is paying off for European stocks. The long-awaited promise of an earnings recovery is becoming reality this year, and in the process is setting eurozone stocks apart in a very good way from their U.S. peers.

The Euro Stoxx index of eurozone companies has set a new post-financial-crisis high in recent days, up 13.3% for the year in local-currency terms and 24% in dollar terms, versus 15.3% for the S&P 500. ETFs such as the non-currency hedged SPDR Euro Stoxx 50 have tracked this performance.

Moreover, the gains this year for Europe are more about companies actually making more money, not investor appetite for ever increasing earnings multiples, as has happened in the U.S. Indeed, expectations of profit growth have been revised up for 2017 in Europe this year, but down in the U.S., UBS notes, a rare sight. While the S&P 500 forward price-earnings multiple has risen to 18 times this year from 16.8 at the end of 2016, the metric for the Euro Stoxx has climbed only to 14.9 from 14.3, according to FactSet. That is well below the 16.7 times recorded in April 2015, when the start of quantitative easing and sharply falling bond yields helped lift European stocks.

Monetary policy is still loose, and the European Central Bank has signaled a cautious approach to scaling down stimulus. But Europe’s domestic growth story now appears to be firing on all cylinders. The eurozone Economic Sentiment Indicator released Monday hit its highest level since January 2001.

Meanwhile, a headwind has eased: the rapid rise in the euro earlier in the year weighed on equities as it raised the risk of a hit to profits and growth. But growth has continued unabated and the heat has come off the euro. Instead, the focus now is more on how much ground the dollar might recover.

That, perhaps, points to the bigger risk for European equities now. This could come in the form of spillover effects from the U.S., where the recovery is much more extended, and where a rise in inflation could upset the low bond yields that have underpinned gains in risky assets like stocks. Uncertainty over fiscal and monetary policy is higher too.

Europe, by contrast, is earlier in the business and financial cycle, and inflation is far from being a problem. There are still challenges, like the standoff over Catalonia, although that has only held back Spanish stocks. But for now the bigger questions for markets lie on the other side of the Atlantic.

Write to Richard Barley at Markets

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