Europe Is Still In The Throes Of Covid-19, But Its Stocks Are Rallying

European stocks have been on the rise as international investors reposition their portfolios for the global economy to return to normal—a trade that hinges on smooth reopenings in the region.

The pan-continental Stoxx Europe 600 index has gained 4.5% so far this month, pulling ahead of major U.S. gauges, and on Friday hovered close to its highest point in more than a year. The S&P 500 has added 3.5% in the same period and the Russell 2000, an index of small-cap U.S. companies, has increased 6.9%. The Nasdaq Composite has gained 1% so far this month.

Analysts say this is due to a rotation from growth to value stocks: Investors have been snapping up shares of companies hit hard by the pandemic and selling those that benefited from stay-at-home orders. Europe is emerging as a beneficiary of this trade, which banks on a strong economic rebound.

“Europe is predominantly a value market, the U.S. is predominantly a growth market,” said Kasper Elmgreen, head of equity investing at Amundi. “This rotation benefits Europe disproportionately.”

Value stocks are thought to be trading below what they are currently worth. They are typically in established industries and pay dividends, and include banks, energy and industrial companies, which are also more sensitive to the economic cycle. Growth companies are younger and perceived to be innovative, with potential to do well in the future, such as technology.

But delays to the European Union’s procurement of vaccines is likely to result in its member states keeping social-distancing and travel restrictions in place for longer than countries that are inoculating their populations faster, such as the U.S. and Israel. This might mean that Europe’s economic rebound is slower and weaker. Italy reimposed stricter curbs in several regions last week and plans to lock down nationally over Easter.

“We are finding a little bit more opportunity outside of the U.S. [Value stocks] look cheaper and more undervalued overseas,” said Brent Fredberg, director of investments at Brandes Investment Partners in San Diego. “Now you’ve still got a long way to go in many of these companies, even though they’ve rallied hard.”

A key reason for Europe’s recent strong stock-market performance is the composition of indexes. The Stoxx Europe 600 is more heavily weighted toward industries that are considered to be value, such as financials at 17%, industrials at 16% and energy companies at 5%. Its weighting for technology and communications is 10%, compared with 37% for the S&P 500.

Amundi’s Mr Elmgreen has bought shares of European auto makers and companies that produce construction materials recently, and said he is “significantly underweight” U.S. tech, meaning he owns less than the benchmark he tracks.

Another driver of Europe’s performance is the bond market. The sense of optimism about economic growth has also driven fund managers to dump safe-haven assets such as sovereign debt, causing yields to rise and prices to drop. Government bond yields are used as a reference for the cost of debt in the broader market, including loans to companies. That rise in yields implies higher financing costs, benefiting lenders.

European banks have been among the best performers so far this year. Investors have been expecting the recent rise in yields to improve their net interest income, a key source of revenue. French bank Natixis SA has surged 47%, while Amsterdam-based ING Groep NV and Spain’s Banco de Sabadell SA have both risen 32%.

The Vanguard FTSE Europe ETF is up 5.6% for the year and the iShares Europe ETF has also risen 5.5%. Another iShares ETF that invests in European financial firms has climbed 12%.

Companies in sectors still curbed by government restrictions have also jumped. German travel company TUI AG is the biggest winner on the Stoxx Europe 600 this year, soaring 56%. International Consolidated Airlines SA has added 39% and InterContinental Hotels Group PLC has risen 15%.

But whether these gains are justifiable is still a question, according to Simon Webber, a portfolio manager at Schroders with a focus on global equities. “Travel has fundamentally changed, people are used to working productively, meeting and supporting customers remotely,” he said. Aviation stocks in particular “will be heavily scrutinized,” he added.

He has increased his holdings of European banks, but is also looking at buying more growth stocks such as electric-vehicle companies.

U.S. investors’ enthusiasm over Japanese stocks at this time last year turned out to be misplaced, but the market is again on the list of potential ways to diversify. Corporate shake-ups, hints of inflation after years of declining prices, and a trade battle could work in its favor.

Japanese stocks started 2024 off strong, but an unexpected interest-rate increase in August by the Bank of Japan triggered a sharp decline that the market has spent the rest of the year clawing back. Weakness in the yen has cut into returns in dollar terms. The iShares MSCI Japan ETF , which isn’t hedged, barely returned 7% last year, compared with 30% for the WisdomTree Japan Hedged Equity Fund .

The market is relatively cheap, trading at 15 times forward earnings, about where it was a decade ago, and events on the horizon could give it a boost. Masakazu Takeda, who runs the Hennessy Japan fund, expects earnings growth of mid-single digits—2% after inflation and an additional 2% to 3% as companies return more to shareholders through dividends and buybacks.

“We can easily get 10% plus returns if there’s no exogenous risks,” Takeda told Barron’s in December.

The first couple months of the year could be volatile as investors assess potential spoilers, such as whether the new Trump administration limits its tariff battle to China or goes wider, which would hurt Japan’s export-dependent market. The size of the wage increases labor unions secure in spring negotiations is another risk.

But beyond the headlines, fund managers and strategists see potential positive factors. First, 2024 will likely turn out to have been a record year for corporate earnings because some companies have benefited from rising prices and increasing demand, as well as better capital allocation.

In a note to clients, BofA strategist Masashi Akutsu said the market may again focus on a shift in corporate behavior that has begun to take place in recent years. For years, corporate culture has been resistant to change but recent developments—a battle over Seven & i Holdings that pits the founding family and investors against a bid from Canada’s Alimentation Couche-Tard , and Honda and Nissan ’s merger are examples—have been a wake-up call for Japanese companies to pursue overhauls. He expects a pickup in share buybacks as companies begin to think about shareholder returns more.

A record number of companies have also delisted, often through management buyouts, in another indication that corporate behavior is changing in favor of shareholders.

“Japan is attracting a lot of activist interest in a lot of different guises, says Donald Farquharson, head of the Japanese equities team for Baillie Gifford. “While shareholder proposals are usually unsuccessful, they do start in motion a process behind the scenes about the capital structure.”

For years, money-losing businesses were left alone in large corporations, but the recent spate of activism and focus on shareholder returns has pushed companies to jettison such divisions or take measures to improve them.

That isn‘t to say it is going to be an easy year. A more protectionist world could be problematic for sentiment.

But Japan’s approach could become a model for others in this new world. “Japan has spent the last 30 to 40 years investing in business overseas, with the automotive industry, for example, manufacturing a lot of the cars in the geographies it sells in,” Farquharson said. “That’s true of a lot of what Japan is selling overseas.”

Trade volatility that hits Japanese stocks broadly could offer opportunities. Concerns about tariffs could drag down companies such as Tokio Marine Holdings, which gets half its earnings by selling insurance in the U.S., but wouldn’t be affected by duties. Similarly, Shin-Etsu Chemicals , a silicon wafer behemoth that sells critical materials, including to the chip industry, is another potential winner, Takeda says.

If other companies follow the lead of Japanese exporters and set up shop in the markets they sell in, Japanese automation makers like Nidec and Keyence might benefit as a way to control costs in countries where wages are higher, Farquharson says.

And as Japanese workers get real wage growth and settle into living in an economy no longer in a deflationary rut, companies focused on domestic consumers such as Rakuten Group should benefit. The internet company offers retail and travel, both of which should benefit, but also is home to an online banking and investment platform.

Rakuten’s enterprise value—its market capitalization plus debt—is still less than its annual sales, in part because the company had been investing heavily in its mobile network. But that division is about to hit break even, Farquharson says.

A stock that stands to benefit from consumer spending and the waves or tourists the weak yen is attracting is Orix , a conglomerate whose businesses include an international airport serving Osaka. The company’s aircraft-leasing business also benefits from the production snags and supply-chain disruptions at Airbus and Boeing , Takeda says.

An added benefit: Its financial businesses stand to get a boost as the Bank of Japan slowly normalizes interest rates. The stock trades at about nine times earnings and about par for book value, while paying a 4% dividend yield.

Corrections & Amplifications: The past year is expected to turn out to have been a record one for corporate earnings in Japan. An earlier version of this article incorrectly gave the time frame as the 12 months through March. Separately, Masashi Akutsu is a strategist at BofA. An earlier version incorrectly identified his employer as UBS.

Europe Is Still In The Throes Of Covid-19, But Its Stocks Are Rallying

Certain shares surge as investors look for beaten-down stocks.