European stocks opened for business in 2014 to a slew of economic good news.

Manufacturing activity in the Eurozone, as measured by the Markit PMI, climbed to a 31-month high in December. The rise was driven by new export orders as well as manufacturing output. Unemployment in Germany fell for the first time in five months in December, as the number of jobless people fell by 15,000, much more than analysts’ expectations. Spain, too, recently reported a significant dent in its unemployment, the largest fall since June of last year.

European indices powering ahead

Meanwhile, the Stoxx Europe 600 Index has been rising for the last two years and is now perched at the highest levels seen since May 2008. The MSCI Europe index gained 5% in just the last three weeks of December.

Most analysts and investors are of the view that further bullishness is in store for European stocks, though most of the re-rating due to the much-anticipated European recovery may already be priced in.

So, 2013 was the year to buy into the European recovery dream. What of 2014?

2014 – The year of wish fulfillment

“With valuation and sentiment having risen significantly, expectations are higher than they have been for some time. 2014 should be the year when we find out whether we get ‘wish fulfillment’ or whether the region remains condemned to a long and hard slog,” says Graham Secker, Morgan Stanley’s Equity Strategist for Europe in his research note on equity strategy for Europe in 2014. “We are optimistic on European equities for this year, although a probable inflection point in global monetary policy provides for heightened uncertainty along the way.”

Europe gained at the cost of EM in 2013

European Earnings

Currency and fiscal problems drove investors out of EM into the comforting opportunity of a European recovery.  In the above chart, Asia and emerging markets were the worst performers in 2013, while Europe and the UK gave investors the best returns.

Valuations in Europe 2014

According to the chart below, European equity valuations on the basis of the next 12 months PE ratio for the MSCI Europe Index are close to 10-year highs.

2-equity-valuations

“Equity valuations are likely to rise further in the early part of 2014, driven by a further fall in Europe’s risk premium and continued equity inflows,” they say. “However, we are likely to see some downward pressure on valuations later in the year as economic growth improves and investors start to consider higher rates into 2015.”

A base case valuation target for MSCI Europe is projected at 13.6x 12m PE.

European earnings an area of concern

Morgan Stanley observes that European stocks have been rising over the last two years in the face of declining EPS, as shown in this chart.

3-rising-stocks-falling-eps

As a result, European stocks now look somewhat expensive when juxtaposed against global peers such as the US, Japan, even EM.

Morgan Stanley analysts estimate that European EPS would grow 10% in 2014 and 12% in 2015, anticipating that European margins will start growing after a lull of three years.

Most of the EPS growth in 2014 will likely be contributed by IT, banks, transport and materials.

European investing strategies for 2014

Morgan Stanley is overweight on Germany and Spain but underweight on France and Italy. Financials are expected to benefit from banking reform and will report a bounce in ROE. Corporates are expected to indulge in hectic M&A, restructuring and make cash pay-outs to shareholders.