The European rally is running on oil, not growth

THE EUROPEAN rally that pushed the STOXX 50 to record ground last week looks, on its face, like a story of recovering growth. Manufacturing showed its sharpest expansion in recent memory, according to S&P Global. Earnings estimates for blue-chip companies are being revised upwards. The headline is cheerful enough. The details are less so.

The real driver of the advance is not growth. It is oil. On August 2nd, Mr Trump called off a planned strike on Iran and announced that negotiations would resume. Brent crude plunged more than 7% in early trade, settling around $84 a barrel. The relief rally that followed has been mislabelled as an earnings story. It is an energy-risk story wearing earnings clothing.

The energy illusion

Estimates for STOXX 600 companies point to 17.3% earnings growth in the second quarter, according to LSEG I/B/E/S data. That is the best rate in more than three years. The trouble is that the energy sector, whose profits soared 122.6% as the Iran conflict disrupted supplies through the Strait of Hormuz, is inflating the average. Strip out energy and the aggregate profit growth rate falls to 7.2%. Revenue growth of 11.5% is indeed the best since the fourth quarter of 2022, ending 13 quarters of flat or declining sales. But it is not the kind of reacceleration that justifies a market trading at record levels.

To be sure, earnings outside energy are no worse than the market had feared. Erste Group, an Austrian bank, puts aggregate revenue growth at 12% and earnings at 17% for companies that have already reported. Some of the biggest names delivered: Bayer beat second-quarter estimates and reaffirmed its sales outlook; HSBC topped forecasts and raised its net interest income target. AI-related stocks benefited from Palantir's raised revenue guidance, with ASML and Infineon both up more than 3%.

Yet the earnings picture is a story of concentration, not breadth. A handful of companies with pricing power or exposure to geopolitical windfalls are doing the heavy lifting.

The wrong kind of growth

The companies that disappointed are worth a closer look, because they reveal where European growth is genuinely thin. Zalando, Europe's largest online fashion retailer, reported gross merchandise volume growth of 20.7% in the second quarter. The stock fell 15%. The reason: nearly all of that growth came from its acquisition of former rival About You. On a pro forma basis, underlying GMV grew just 4.4% and revenue a meagre 1.1%. Management narrowed its full-year guidance. The consumer is not reviving; Zalando is buying its growth.

Lufthansa is less flattering still. Profit expectations were missed and the group lowered its full-year EBIT guidance to €1.7bn-€2.2bn. The share price dropped 9%. An airline that has to cut its outlook after reporting top-line growth is not a sign of recovery. Hugo Boss followed a similar pattern, with sharp declines in both sales and EBIT.

The pattern is familiar. Energy, defence and a few technology names are carrying the index. The broader economy - retail, travel, fashion, industrials - is doing the minimum required to avoid looking broken. That is not the foundation of a sustained rally.

The geopolitical tightrope

The incentive structure governing this rally is geopolitical rather than economic. The Strait of Hormuz remains effectively closed. Iran continues to attack commercial vessels; the US enforces a blockade on Iranian shipping. Traffic through the strait, through which about a fifth of the world's oil passes, is almost non-existent. The conflict, which began on February 28th, has whipsawed crude prices from a Brent high of more than $126 a barrel in April to below pre-war levels last month, and back again.

The market is pricing the hope that the latest round of talks will reopen the strait. That hope is real. It is also fragile. Tehran has denied that substantive talks are underway, with its foreign ministry saying negotiations are limited to routing discussions with Oman. The Houthi rebels in Yemen have added another layer of disruption, attacking Saudi-flagged tankers and forcing ships onto longer, more costly routes through the Suez Canal. Analysts have warned that Brent could reach $120 in the fourth quarter if the strait is not reopened.

The European Central Bank, caught between these forces, has been on the defensive. It raised rates by 25 basis points in June, to 2.25%, citing inflation pressures from the war. It held steady in July, watching incoming data. The ECB's dilemma is structural: an energy shock that raises prices while suppressing growth is the central banker's worst-case scenario. A sudden reopening of the strait would ease inflation but would also slash the energy profits propping up European earnings. Either way, the economy bears the cost.

What the PMI actually shows

The manufacturing PMI data, which S&P Global described as signalling "the sharpest expansion in euro area manufacturing production", is worth interpreting with care. Purchasing managers' indexes are survey-based and volatile. The expansion they recorded in July coincided with the peak of the oil-price shock, which would have boosted production at energy-intensive firms and inflated order books through precautionary ordering. When oil prices fall, the reverse can happen: order books shrink and production slows. The PMI's sharpness may be a function of volatility, not structural strength.

That said, the services PMI - released on August 5th - and the composite index will provide a better read on whether the broader economy is recovering or merely reacting to a temporary lull in geopolitical panic. The data gap, for now, is the one between headline optimism and sector-level reality.

The investor's dilemma

European equities are up nearly 24% over the past year. At record levels, the margin for error is thin. The rally has been built on three pillars: relief from oil, windfall energy profits, and the hope that the war ends soon. Each of them can be undermined.

The risk is not that a deal fails. It is that a deal succeeds. A reopened strait would send oil prices lower, which would be good for consumers and the ECB but bad for the energy companies whose profits are currently supporting European earnings estimates. TotalEnergies and Repsol, whose shares climbed on strong results, would face a far more challenging pricing environment. The market would have to find earnings support elsewhere - in sectors that, at present, are not delivering it.

The broader lesson is about the quality of a recovery that runs on geopolitical risk premium and energy rents. When earnings growth of 17% collapses to 7% once the oil sector is removed, the valuation case for the index as a whole becomes harder to sustain. It is not that the rally is a bubble. It is that it is running on a fuel source that could disappear precisely when the peace it depends on arrives.

Better to treat the record high as a reminder than a signal.