With No End in Sight, War Threatens Europe’s 2023 Stock Rally

(Bloomberg) — One year after Vladimir Putin invaded Ukraine, Europe’s stock rally is still at risk from a possible escalation in the war.

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While the region’s equities have recovered from declines seen in the immediate aftermath of Russia’s attack, they are now more vulnerable to sharp shocks after this year’s almost 8% rally. If the war worsens, it will not only stoke geopolitical uncertainty in Europe but also amp up pressure on energy and food prices, increasing economic gloom and weighing on corporate profits.

“It’s clear the market views the risks as lower compared to the beginning of the war, and while elements of the rally are understandable, the margin of safety in European stocks has now been eroded,” said Sophie Lund-Yates, lead equity analyst at Hargreaves Lansdown. “That means any unexpected escalations or volatility is likely to result in a sharp market reaction.”

Europe’s main equity benchmark has rallied in 2023 as signs of cooling inflation and better-than-expected earnings fueled economic optimism. But war isn’t far from investors’ minds, with fund managers in a Bank of America Corp. survey seeing worsening geopolitical concerns as the second-biggest threat to markets, after sticky inflation. Most don’t expect a peace treaty this year.

The polarization between stock winners and losers, coupled with a weaker euro, suggest not all risks have been priced out, Barclays Plc strategist Emmanuel Cau said. European energy shares have soared 20% in the past year as Russia curtailed the supply of natural gas in response to sanctions, while rate-sensitive real estate companies have slumped 29%. The euro has recovered a big chunk of the losses through September, but remains lower than pre-war levels.

Read More: War Reaches One-Year Mark With No End in Sight

Recent developments show an escalation can’t be ruled out. Support for Putin’s war has hardened domestically, even as casualties soar. And Moscow has suspended its nuclear treaty with the US, a move that President Joe Biden called a “big mistake,” although he said he doesn’t believe it signals the Russian leader will use nuclear weapons.

Energy Crunch

A potential energy crunch is among the big risks from the war. While a mild winter helped Europe avert a crisis this time around, stockpiles could dwindle again if the war drags on into the colder months. Another jump in energy costs would also further compress corporate profit margins.

“The need to replace a historically cheap energy source will remain a challenge,” said Charlotte Ryland, co-head of investments at CCLA. She doesn’t see profits at oil and gas companies soaring again this year as commodity prices fall back from historic highs.

With the war forcing a shift in governments’ long-term investments, spending on renewables and defense firms may get a boost. UBS Global Wealth Management strategists said they see opportunities in areas including commodities, green tech, energy efficiency and cybersecurity.

“Even when the war ends, we’ll be more reluctant to draw on supply from Russia because it’s not a reliable source, and so energy and chemicals sectors have to necessarily innovate,” said Joost van Leenders, senior investment strategist at Van Lanschot Kempen. “The push for renewable energy is the only way that Europe can become more independent.”

Food Costs

Another sector likely to be disproportionately affected if the conflict continues is food and drinks, where supplies of some items have been disrupted in the past year.

Bloomberg Intelligence strategists Tim Craighead and Laurent Douillet said profitability of the food industry “faces a potentially long-term test” as restricted supplies of key Ukrainian sunflower, oil, corn and wheat add to a rise in prices.

Higher costs will add to price pressures that are already hurting consumers and keeping central bankers hawkish.

The surge in energy and food prices left consumers with less money to spend elsewhere, while at the same time raising costs for businesses, resulting in far weaker growth and inflation that’s jumped much more than expected pre-war, Berenberg economists wrote in a note. As a result, they expect real GDP in 2024 to be 3.6% lower and the price level 8.9% higher than it may have been otherwise.

Cyclicals at Risk

Economically sensitive sectors are at risk of reversing an outperformance against so-called defensive peers if the war escalates. Cyclicals were hammered early last year as investors factored in the impact of the invasion on economic growth. In the past few months, however, such stocks have beaten counterparts that are seen as relatively safer.

All in all, the outlook for European stocks is getting dimmer after the rally. Strategists in a Bloomberg poll expect the Stoxx 600 to end the year below current levels on deteriorating economic momentum.

Investors have poured $40 billion into global equity funds since the war began, a fraction of the $354 billion piled into cash, according to a Bank of America report citing EPFR Global. And of late, they’ve been dumping both in favor of bonds as they position for higher-for-longer rates in the US.

Beata Manthey, head of European equity strategy at Citigroup Inc., expects geopolitical risks to keep a lid on European equity valuations as the boost from lower gas prices, a weaker dollar and China’s reopening is now priced in.

“As for the rally, we wouldn’t be chasing it from here,” she said.

–With assistance from Michael Msika.