War in Ukraine forces European bulls to reverse bets

European stock indices have recouped most of the losses suffered since President Vladimir Putin sent Russian troops to Ukraine. That doesn’t necessarily mean traders are optimistic.

Investors around the world say they remain wary of investing within the European continent, even though the pan-continental Stoxx Europe 600 is down just 0.2% from its close the day before the invasion. The euro, meanwhile, has recovered slightly from the nearly two-year low the currency hit earlier this month, hovering around $1.10 on Thursday.

The recent surge in European equities has been accompanied by a broader rally that has boosted US and Asian equities alike, sending the S&P 500 up 7% since the war began. Many investors and analysts have attributed the global recovery to bargain hunting. Some strategists have also suggested switching into equities as a hedge against inflation.

Still, many investors are reluctant to put their full trust in European markets. With the European Union dependent on Russia for around 40% of its gas, many investors have decided that the potential for rising inflation, fresh supply chain disruptions and even recession is too much of a risk. Instead, they are relocating to regions they believe are more isolated from the war, including the US and some emerging economies.

Many investors had expected Europe to post outsized gains in 2022 after two years of US dominance in global stock markets. Compared to the US, where indices are influenced by tech giants, European markets are more dominated by energy companies and bank stocks, which perform well as inflation rises.

The war destroyed those bets. Investors have withdrawn $23.4 billion from Western European equity-oriented mutual funds and exchange-traded funds in the three weeks between the Russian invasion and March 16, data from fund flow tracker EPFR shows. That’s more than double the outflows in the first three weeks of the pandemic sell-off in early 2020.

Meanwhile, investors poured $40.5 billion into U.S. equity funds in the three weeks ended March 16, EPFR data shows.

James Beaumont, head of multi-asset portfolio management at Natixis Investment Managers Solutions, said his team has been forced to reorganize its model portfolios.

Last year, his team allocated portfolios based on expectations that the US market — and growth stocks in particular — would outperform. As 2022 began, they shifted their bets to more bullish European and value stocks.

“We thought we were well positioned for January and February. Then Putin put an end to it,” Mr Beaumont said.

Recently, he said, his team made the switch to a neutral stance on Europe. “We don’t think you can act in this environment because there could be a peace deal tomorrow,” he said.

Recent polls by BofA Global Research show that global fund managers have unwound similar bets. For example, in January, 35% net of respondents said they were overweight European Union stocks, while 5% net overweight US stocks.

By March, the trend had reversed: 18% net of fund managers were underweight European stocks, the survey showed, while 12% net were overweight US stocks.

“There’s all these different anecdotes that don’t inspire a lot of confidence,” said Chris Montagu, head of global quantitative research at Citi Research. Among the worrying signs, he said: downgrades in gross domestic product forecasts for the region.

This month, economists at Citi reduced their GDP forecasts for the world and the eurozone. Economists now expect eurozone GDP growth of 2.3% in 2022, up from 3.3% in February. They also raised inflation expectations, forecasting a 6.5% rise in euro-zone consumer prices for the year, up from 4.6% last month.

The consequences of the tough economic sanctions against Russia are already being felt around the world. WSJ’s Greg Ip joins other experts in explaining the significance of what has happened so far and how the conflict could transform the global economy. Photo illustration: Alexander Hotz

Data suggests the recent rally in global stock markets is unconvinced, Mr Montagu said, with index futures showing investors expect further pain for the Stoxx Europe 600 and Germany’s DAX index. Short bets against both indices — that is, bets that they will fall — have remained firmly in place, he said. “We don’t see any newly established long positions,” he said.

Investors also expect more pain for the euro. Data from the Commodity Futures Trading Commission shows that on a net basis, hedge funds continue to bet on the euro weakening against the dollar.

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Viraj Patel, global macro strategist at Vanda Research, advises clients to maintain bearish positions against the euro as oil prices fluctuate and the European Central Bank hikes interest rates at a slower pace than the Federal Reserve.

“The trade shock we have experienced in recent weeks will weigh on the euro,” he said. “Gone are the days when people thought $1.30 was fair value.”

Write to Caitlin McCabe at caitlin.mccabe@wsj.com

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