European stocks are off to their best-ever start to a year with a 10% increase in January, exceeding those in the US. But, this rally can go either way.

European stocks are now popular. However, it won't take long for market sentiment to turn negative yet again.

Stocks in the euro area are off to their best-ever start to a year with a 10% increase in January, exceeding those in the US. However, renowned investors like BlackRock Inc. and Amundi SA caution that markets are becoming too optimistic about possible risks.

This rally might go in a number of different directions. Earnings downgrades are accelerating, but the European Central Bank is sticking to its hawkish attitude in the face of the recession since inflation is still high even if it is lowering. And the conflict in Ukraine, which started over a year ago, has no sign of ending.

Kasper Elmgreen, head of equities at Amundi, warned against assuming everything is well just because markets are rising. "We are now extremely confident that 2022's resiliency will fail. The market has not yet recognised the size of the impending profit downgrades”.

Sentiment has improved as a result of lower oil costs, indications that inflation is slowing, and China's faster openings. The Euro Stoxx 50 Index has increased by 27% from its September low. After almost a year of redemptions, money is also starting to trickle back into European stock funds.

The advances so far appear to have been driven by short-sellers covering positions, although major asset managers have remained cautious, as per trade data. Stock market optimism, according to analysts at the BlackRock Investment Institute, has arrived too soon, while those at Goldman Sachs Group Inc. and Bank of America Corp. warned that the best of the 2023 surge may already be gone.

Conflict in Ukraine

Russia's dominance over Europe's gas imports continues to be a danger to economic expansion. The region avoided an energy crisis this time around thanks to a warmer winter, but if Russia stops supplying, greater governmental involvement may be required.

Vladimir Putin is preparing a fresh attack in Ukraine over a year after an invasion that was meant to last a few weeks, while the US and Germany are deploying tanks there as part of a larger international push to arm the country with more potent weaponry. The actions hint at the possibility of a conflict escalation.

Aneeka Gupta, a director of Wisdomtree UK Ltd., said that the energy conflict "may persist for a lengthy period."

“We can't always count on good weather, so we'll need to continue with steps like building up our gas reserves and restricting energy use”.

Painful Earnings

Going into the reporting season, analysts have been cutting their profit projections, and some strategists are pushing for even bigger cuts given the background of slowing growth. Companies are also finding it more challenging to raise prices at a time when demand is dropping due to the decrease in inflation.

As margins contract and debt servicing costs rise, the combination of sustained inflation and increasing rates will put pressure on many firms' cash positions.

In Europe, flat profit growth is expected this year, according to some experts. Whereas other market strategists are more pessimistic. Those at Goldman Sachs, UBS Group AG, and Bank of America estimate earnings would drop by 5% to 10%, predicting greater share losses as values catch up to the lower estimates.

Inadequate Guidance on Policy

Based on the most recent communication from ECB officials, they plan to continue raising interest rates unless they notice a more significant reduction in inflationary pressures. Nonetheless, stock market investors remain upbeat about the economy's gentle landing and rate reduction later this year.

This contradiction has caused shares to move in line with bonds, where investors are concentrating on a recession and might cause shares to collapse if the ECB does continue on its hawkish path for an extended period of time.

Recession Difficulties

The avoidance of the oil crisis and indications of strong economic growth has led some experts, notably those at Goldman Sachs, to believe that the eurozone would completely escape a recession this year. But based on other market strategists, it’s too early to predict.

In reaction to strong monetary tightening, "we foresee a severe loss of growth momentum, but markets are not priced for this," said Bank of America strategist Sebastian Raedler. As statistics start to indicate weaker growth, he projects a decline of roughly 20% for the Stoxx 600 Index.

Early Optimism Regarding China

The road ahead may be difficult given that early optimism over China's reopening from Covid-related lockdowns has already been factored in. In the second-largest economy in the world, consumer confidence is still very low, the population is declining for the first time in 60 years, and the housing market is still in a slump.

Due to their reliance on China for a sizable amount of their sales, European manufacturers of luxury products, auto manufacturers, and miners are among the businesses that stand to lose the most if the recovery is longer than expected.

(Bloomberg.com, Reuters.com)