Key Takeaways
- In the second half 2026, European equity markets are not cheap, with key indexes close to record highs.
- Despite the resumption of hostilities between the US and Iran, most defense stocks under Morningstar coverage are still undervalued—but investors are skeptical about spending pledges.
- Increased oil supply should overtake any disruption from the conflict, which makes energy sector stocks less attractive.
With the US-Iran peace deal now officially null and void, investors entering the second half the year are once again anxiously following news headlines. But there are signs that the disruptive impact of this conflict is lessening, certainly in the energy sector.
At this point of the year, European equity markets are not cheap, with main indexes like the STOXX Europe 600 and FTSE 100 trading close to all-time highs. The Morningstar Europe Index is trading at just a 4% discount to its fair value estimate, which a small margin of safety given the level of uncertainty in the world.
Still, there are plenty of sectors that offer attractive stocks to buy.
Undervalued European Stock Picks
- Leonardo LDO
- Rheinmetall RHM
- Melrose MRO
- Roche ROP
- Novo Nordisk NOVO B
- SAP SAP
- Thomson Reuters TRI
- RELX REL
Are Defense Stocks Buys or Sells?
With so many active conflicts going on, including Ukraine and Iran wars, defense stocks would appear to be well supported by events. But after a long period of positive inflows into defense funds, two of the last three quarters have seen outflows as investors have cooled on the theme.
Largely this comes down to a lack of belief that governments will come through with their spending plans. Under pressure last year from President Donald Trump, NATO members agreed to increase defense spending to 3.5% of GDP by 2035. But with current spending levels well below this, investors are doubtful.
Regardless of whether countries hit the exact numbers, we believe the direction of travel is positive, defense spending is increasing, and many countries, like Germany, have no choice but to spend, to restock weapons given to Ukraine. The chart above shows the significant increase in defense fund assets held by European investors. Most of the defense stocks under Morningstar coverage look highly attractive currently and the upcoming earnings season could be a catalyst for investors to change their minds about the sector.
Is the Outlook for Oil Prices Bearish?
The Morningstar Global Energy Index fell by almost 12% in the second quarter as oil prices fell on the agreement between Iran and United States to the end war. Now, with the peace deal in tatters and oil prices spiking again, some investors might be thinking that it would be wise to stay invested in the sector in the hope that continued disruption will keep oil prices elevated, and profits flowing for energy firms.
But it’s our contention that as the conflict wears on, the disruptive effect is lessening, all the while supply from other sources is increasing. By September of this year, we believe increased oil supply will have overtaken any disruption, which should dampen oil prices. As things stand in the European energy sector, we see few attractive opportunities.
An Improving Outlook for Healthcare Sector Stocks
Another sector that has materially underperformed the market, both over the last quarter and the last year, has been healthcare. Traditionally a defensive sector, healthcare is often seen as good place to park cash in uncertain times. This hasn’t been the case however, as other concerns, namely drug regulation, patent cliffs, and tariff threats, have put investors off.
We believe these concerns have slowly faded or have been resolved for the most part. Fears over the US government setting pricing of drugs remain, but this seems to be confined to certain high-cost drugs and not a widespread concept. Specific tariff concerns around the pharma industry have all but disappeared, as the major firms committed to investing in manufacturing facilities in the US in a successful effort to appease the US administration.
Lastly, worries about patent cliffs still exist. But our analysis points to increased sales from existing products and a strong pipeline of new drugs, which together should more than offset drugs coming off patent in the next few years.
Valuations of healthcare stocks have been rising, with the sector now trading at just a 10% discount to our fair value estimate. A strong earnings season could narrow this discount further.
Signs of Life for Software Stocks
Weak revenue growth in the IT services and software sectors has intensified speculation that AI had eroded demand. This was compounded early this year by the release of a Claude plug-in by Anthropic, which effectively enabled businesses to code their own software. Amid the “SaaScocalypse” earlier this year, Morningstar reviewed its entire coverage universe and subsequently downgraded the moat ratings on many of our IT services and software stocks.
Software Revenue Growth Has Trended Down But Is Stabilizing
Unlike some investors who have been shying away from the sector, we believe there are many stocks in both categories that are not significantly impaired by these trends. Sales have been trending negatively, but this could be down to firms trying to “do more with less” under budget constraints rather than no longer needing these services and products. We believe software revenue could start to trend more positively in the near term, while in IT services we believe already improving trends could continue.
