What is the outlook for the European financial markets given the deterioration of the geopolitical context?

By Tilmann Galler and Vincent Juvyns, Global Market Strategists, J.P. Morgan Asset Management

Since 24 February 2022 and the start of the conflict in Ukraine, Europe has been going through one of the most difficult periods in its history. Firstly, from the human perspective, the war in Ukraine has already claimed many victims and has caused the displacement of more than 10 million refugees.

Secondly, in geopolitical terms, this conflict is taking us back to the darkest days of the Cold War. As these lines are being written, diplomatic efforts are continuing, and although the situation on the ground is still critical, negotiators are saying that tentative progress is creating a glimmer of hope that a diplomatic solution to this conflict might be found.

«The worst is never certain», a view the financial markets seem to have taken in recent weeks as, after losing up to 20 percent since the start of the year, the MSCI EMU index rebounded by nearly1 10 percent in March. Volatility is still no lower though2 and should stay high as long as financial markets remain uncertain about the development of the conflict and its human, economic and financial cost.

Bank Stocks Hit Hard

Against this backdrop, a cautious approach should be taken to exposure to the European equity markets, although the indiscriminate sell-off trend seen at the start of the conflict was perhaps exaggerated, as the fiscal and monetary policies currently in force should support economic activity generally, and some sectors specifically.

The conflict in Ukraine has hit European bank stocks particularly hard. After reporting a rise of up to 15 percent this year, they have lost a bit more than 14 percent since 23 February. Investors are concerned about the banking sector’s exposure to Russia and the impact of a potential economic slowdown in the eurozone on banking activity.

While these questions are legitimate, they should not cast doubt on the entire sector. The sector has reduced its exposure to Russia by 60 percent since the annexation of Crimea3 in 2014, whereas the maintaining of accommodative fiscal policies should dampen the economic shock, and the gradual phasing out of asset purchases by the ECB should support interest rates and therefore European bank margins.

Accelerated Energy Transition and Return of Value Investing

The terms «recession» and «stagflation» are increasingly being used by economists in their economic analyses of the eurozone, but we aren’t at that point yet. All things being equal, the fiscal measures rolled out by governments and the European Commission, such as the RePowerEU plan, should absorb the economic impact of the energy crisis and accelerate the energy transition within the eurozone.

Investors have not failed to notice this as, since 24 February, the European energy sector has surged by more than 30 percent4. The rebound in this growth sector is all the more remarkable as it has occurred against a background of interest rate hikes (+76 basis points for the 10-year German interest rate since the start of the year5), exacerbated by the rise in inflation and the ECB’s wish to step up the reduction of its asset purchases.

Over the next few months, interest rates should continue to rise given persistent high inflation due to the current energy crisis. As at the start of the year, this should work in favor of «value» stocks rather than «growth» stocks. For instance, sectors such as industry, energy and healthcare are some of the only ones to report a positive performance this year.

Uncertain Future

In summary, the war in Ukraine is an event with major human and geopolitical consequences and its development and economic and financial impact remain uncertain. The worst may never happen, however, and although volatility should remain high in the financial markets, panicking is generally bad advice for investors.

Caution may be the best policy in the short term but, in the medium and long term, the European project should come out of the Ukraine crisis stronger, as was the case after the Covid crisis. The ECB’s alertness to inflation and the huge investments made to accelerate the energy transition are factors that should support the European markets and, particularly, the renewable energy sector and «value» sectors, which will benefit more from the rise in interest rates and the catch-up movement that will be seen on the day when the conflict in Ukraine is hopefully brought to an end.

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1Source: Refinitiv Datastream, MSCI EMU, data at 31/03/2022
229.9 for the VSTOXX 50
3Source: The Bank for International Settlements
4Source: Refinitiv Datastream, MSCI EMU Renewable electrical, data at 18/03/2022
5Data as of 31/03/2022

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