Europe downgraded to unattractive: The energy shock is not over, and earnings are likely to show it

•    First-quarter earnings look resilient, but we do not think this should be extrapolated. The full impact of higher energy costs, weaker demand and tighter financing conditions is likely to show up more clearly in the next few quarters.

•    Europe’s large exporters and energy-related sectors provide some earnings cushion, but this does not fully offset the pressure on domestic consumers, services, SMEs and energy-intensive industries.

•    We remain selective within Europe. We prefer structural opportunities in defence, power infrastructure and technology, while staying cautious on broad Europe exposure, consumer sectors, domestic industrials and small caps.

We are downgrading European equities from Neutral - 2.5 Stars to Unattractive - 2.0 Stars. This is not a crisis call — inflation remains well below its 2022 peak, unemployment is still near historic lows, and large-cap multinational exporters continue to support index-level earnings. However, the macro investment backdrop has deteriorated materially: growth is approaching stagnation, inflation is reaccelerating, ECB policy flexibility is being compressed, and the resilience in Q1 earnings has yet to fully reflect rising energy costs and weakening demand. More importantly, compared with the Asian markets we favour, Europe no longer offers a sufficiently attractive risk-adjusted return profile.

In March 2026, we downgraded European equities from Attractive - 3.0 Stars to Neutral – 2.5 Stars on two core premises: Europe’s structural vulnerability as a net energy importer, and the end of the low-rate environment that had underpinned the prior recovery thesis. Subsequent data has fully validated that judgement, and the pressures are widening.

Inflation is reaccelerating and spreading into services. According to Eurostat’s May flash estimate published on 2 June 2026, eurozone headline HICP rose to 3.2% year-on-year (from 3.0% in April), with the energy component up 10.9%. A more critical signal is that services inflation re-accelerated from 3.0% in April to 3.5%, while core inflation rose to 2.5%. The rebound in services inflation confirms that the shock is broadening beyond energy into the stickier parts of the inflation basket — precisely the signal the ECB finds hardest to look through.

The energy bill increase is a confirmed schedule, not a forecast. Ofgem confirmed on 27 May 2026 that the UK energy price cap will rise 13% from 1 July, lifting the average household annual bill from GBP1,641 to GBP1,862, explicitly attributed to higher wholesale gas prices driven by the Middle East conflict. Cornwall Insight forecasts a further 2% rise in October, landing at the start of the heating season. More concerning still, European natural gas storage currently sits at approximately 37% of capacity — significantly below the five-year seasonal average of around 50%. The energy shock is no longer a risk scenario; it is locked into the regulatory pricing schedule.

Growth is approaching stagnation and forecasts have been cut. Eurozone Q1 GDP contracted 0.2% quarter-on-quarter — the weakest since Q2 2025 — with PMI data pointing to a further 0.2% decline in Q2 that would confirm a technical recession. The contrast with Asia is direct: Taiwan grew 14.6% in Q1, Singapore 6.0%, China 5.0% and Japan 2.1% — while Europe contracted. The IMF, ECB, and European Commission have all cut their 2026 full-year forecasts to 0.9–1.1%, down 0.3–0.4 percentage points from pre-war estimates of 1.2–1.4%.

Consumers and services are under pressure. Eurozone consumer confidence fell to a 40-month low in May, while the ECB's Consumer Expectations Survey (29 May 2026) showed inflation expectations jumping 2.5 percentage points and growth expectations falling 1.2 points in a single month. The eurozone composite PMI final reading for May fell to 48.5 — down from 51.9 in February — with the first net workforce reductions since early 2021 confirmed.

The ECB raised rates by 25 basis points on 11 June 2026, citing persistent energy-driven inflation and broadening price pressures into services. The low-rate recovery environment that underpinned the prior upgrade has now become an actively tightening monetary policy cycle — the most direct constraint on European equity valuations.

STOXX 600 Q1 earnings beat expectations, and several institutions raised their 2026 EPS forecasts. However, we believe the Q1 strength should not be extrapolated, for three reasons.

First, Q1 only captured the earliest phase of the shock. The war broke out on 28 February; Q1 covered only one month of the full oil price shock. Most companies’ hedging arrangements, inventory buffers, and pricing mechanisms were still providing protection. The real test arrives in the next few reporting seasons — when higher energy costs, higher financing costs, weaker consumer demand, and deferred corporate investment will be more fully reflected in revenues, margins, and management guidance.

Second, pricing power has been materially weakened. Reuters’ analysis of 175 eurozone company earnings calls (covering 2 April to 15 May 2026) found that only 32% of companies were raising or planning to raise prices in response to the Iran war’s cost pressures — compared with nearly two-thirds after Russia’s invasion of Ukraine in 2022. ECB Governing Council member Olli Rehn commented directly on this data, attributing the gap to a less tight labour market, weaker growth, and lower fiscal stimulus relative to 2022. The data makes two arguments simultaneously: demand is weaker — companies cannot pass on costs at the 2022 scale; and it supports framing the ECB’s June move as a precautionary hike rather than the start of a 2022-style tightening cycle.

Third, index resilience is amplified by a handful of beneficiary sectors, masking pressure in the domestic exposure layer. Q1 headline EPS resilience was largely supported by energy and defence companies — similar to the 2022 pattern. The 2022 parallel is instructive: headline index EPS kept rising for two to three quarters after the Ukraine invasion, but ex-energy STOXX 600 EPS weakened earlier and turned negative in selected quarters. This shows how energy-sector strength can temporarily mask underlying earnings pressure, reinforcing our view that Q1 2026 earnings resilience should not be linearly extrapolated.

Around 60% of STOXX 600 revenues are generated outside Europe, and large-cap multinational exporters — ASML, SAP, Nestlé — earning in dollars globally do provide a genuine cushion. But the remaining approximately 40% facing European domestic revenue exposure is under pressure. The European Commission Spring Forecast notes that EU export growth in 2026 is projected at only 0.9%, with domestic demand weakness dragging on overall growth by approximately 0.4 percentage points from the trade side; EU business investment has fallen to an 11-year low (Euronews, 14 May 2026).

Next few quarters’ reporting will be the real test — as the protective buffers are gradually exhausted, the damage to the domestic exposure layer will be fully visible for the first time. We do not expect the results to be flattering.

Markets appear to be pricing diplomatic progress as the end of the energy shock. We disagree.

More than 1.2 billion barrels of oil have been removed from global markets since late February (S&P Global Energy). A signed agreement cannot produce a single one of those barrels back. Even if the conflict ended immediately, ADNOC CEO Sultan Ahmed Al-Jaber has stated it would take at least four months to reach 80% of pre-war output, with full recovery unlikely before the first half of 2027. Qatar’s LNG facilities sustained damage to approximately 17% of export capacity, with repair timelines of three to five years. IEA Director General Fatih Birol described the situation as ‘the vase is broken — permanent consequences for global energy markets.’

Even if a deal is signed, the following costs cannot be removed: marine insurers will only reprice the Hormuz conflict zone after a sustained period of calm; Iran is proposing an environmental fee of approximately USD1 per barrel on transit vessels; and the IRGC has publicly stated it will not return Hormuz to its pre-war state — a published strategic doctrine, not a negotiating position.

Global commodity inventories built up prior to the conflict are currently absorbing demand that would otherwise already be driving prices higher — meaning the full consumer price impact of the supply shock has not yet arrived. ECB Executive Board Member Philip Lane described this directly: the energy supply shock is being ‘masked by inventories’ and ‘even if the initial energy shock starts to reverse, the second-round effects will be with us for a while.’

For European equities, the persistence of the energy shock is not abstract. It means the margin recovery embedded in current 2026 and 2027 consensus EPS estimates is unlikely to materialise on schedule. It means the ECB's June hike is more likely to be the first in a sequence than a one-off. And it means the 16.4x multiple the STOXX 600 currently carries rests on an energy normalisation assumption this section has argued is not the base case.

Defence — Positive

European defence companies have delivered five consecutive quarters of earnings beats, and the structural drivers behind that run are strengthening. Rheinmetall's order backlog stands at approximately EUR64 billion, BAE Systems' at over GBP75 billion — visibility that extends well beyond the current diplomatic cycle. The deeper argument is simple: Europe can no longer rely on Washington, and its governments know it. Defence spending has moved from political commitment to procurement pipeline.

The NATO summit in Ankara on 7–8 July — where Trump is expected to directly confront alliance members who denied US forces military base access during the Iran war — is the next political forcing point for European defence procurement commitments.

The sector is down approximately 6 percentage points year-to-date against the broader index, having given back some of its 150% rally in 2025. We view this as a healthier entry point, not a signal that the thesis has broken.

Investors looking to gain exposure may consider the WisdomTree Europe Defence UCITS ETF - EUR Acc (LSE: WDEF).

Related Article: European Defence: Backlog growth supports a multi-year earnings cycle

Power Infrastructure and Electrification — Positive

Two structural trends are driving demand for European power infrastructure, and they are reinforcing each other. The first is grid modernisation: Europe needs to rebuild and expand its electricity network to handle the energy transition, and the EU has committed EUR584 billion of grid investment by 2030 to do it. Companies like National Grid earn predictable, regulated returns on every euro they invest in this infrastructure — making earnings growth unusually visible.

The second is AI. Data centres are power-hungry, and demand is growing fast: global data centre electricity consumption is projected to rise 50% by 2027 and 165% by the end of the decade. SoftBank's EUR75 billion commitment to build AI data centres in France — with Schneider Electric as the named industrial partner — is the clearest single signal that this investment cycle is real and accelerating.

Both trends require the same thing: more cables, more transformers, more grid capacity. That is what the companies in this space build.

Investors looking to gain exposure may consider The First Trust NASDAQ Clean Edge Smart Grid Infrastructure Index Fund (NASDAQ: GRID).

Related Article: The energy security trade the market has not priced yet

Technology — Positive

We hold a positive view on European technology. The advancement of the EU Chips Act 2.0 and the Cloud and AI Development Act provides medium-term policy tailwinds for domestic technology suppliers; meanwhile, ASML, SAP and Infineon — which together account for more than 50% of the major European technology index — each hold structurally irreplaceable positions in semiconductor equipment, enterprise software and power semiconductors respectively. These companies are participating in the global AI infrastructure buildout in ways that are quieter, but no less defensible, than their American peers.

Investors looking to gain exposure may consider State Street SPDR® MSCI Europe Technology UCITS ETF (LSE: ITEC).

Financials — Neutral (downgraded from Positive)

The net interest margin (NIM) tailwind remains effective in 2026, non-performing loan (NPL) ratios are near historic lows, and capital buffers are strong. However, a rate-hiking cycle driven by an energy shock rather than robust demand acts as a headwind. Stagflation risk is starting to weigh on credit conditions, with the ECB Bank Lending Survey showing weaker fixed-investment loan demand and softer consumer credit demand. Hold, but do not add.

Healthcare — Neutral

Healthcare failed to act as a clean defensive sector during the risk-off shock. The Most Favoured Nation (MFN) drug pricing policy is materially affecting corporate behaviour — EU drug launches fell 35% in the 10 months following the executive order. Stock-specific catalysts are real, but a broader sector re-rating requires policy clarity on MFN scope and enforceability.

Consumer Discretionary, Domestic Industrials, Small Caps — Cautious

Directly bearing the brunt of domestic demand destruction. The composite PMI at 48.5, consumer confidence at a 40-month low, and negative real wage growth — with negotiated pay rising at 2.6% against 3.2% inflation — create a triple headwind. Q2 earnings are the first real test.

The STOXX 600 currently trades at 16.0x 2026 forward earnings. Applying a fair PE multiple of 15x to our 2028 EPS estimate of EUR46.0, our target price is EUR 690, implying upside of approximately 10.2% from current levels. Against Asian markets offering more certain earnings growth at lower valuations, this upside does not look attractive — though Europe does offer dividend yields of approximately 3–4% over the coming years, providing some income support for holders.

In this environment, broad market exposure becomes less compelling, but selective positioning remains valid. Investors looking to maintain exposure may consider the M&G (Lux) European Strategic Value A Inc EUR. For investors who prefer a European-listed, lower-cost alternative, the Amundi Core STOXX Europe 600 UCITS ETF Acc (LSE: MEUS) offers comparable broad European equity exposure.

Table 1: Earnings projections

 Source: Bloomberg Finance L.P., iFAST Estimates. Data as of 29 May 2026.

Declaration

This research report was prepared with the assistance of artificial intelligence (AI) tools. iFAST Financial Pte Ltd does not rely exclusively on AI for content generation; the content of this report — including all investment theses, ratings, price targets and conclusions — has been independently reviewed and verified by the research analyst(s) to ensure accuracy and professional integrity.

For specific disclosure, at the time of publication of this report, IFPL (via its connected and associated entities) holds a NIL position in the abovementioned securities.