Is the optimism of the European stock market justified? No, according to Sebastian Raedler, strategist at Bank of America, who notes that even before the surprise of weaker-than-expected US inflation in October (7.7%, well below estimates of 7.9% and 8 .2% in September), European equities rallied on strong US manufacturing data, but PMI new orders, i.e. underlying demand, are fading. “The market’s forecasted growth scenario is unlikely to materialize given the weakening credit cycle in the US and Europe. We therefore remain negative on European equities, seeing a decline of 14% by the second quarter of 2023; we remain underweight cyclical versus defensive stocks and yield versus growth stocks,” Raedler summed up.
Here’s why Europe’s stock market optimism is misplaced
European equities have rebounded on improving growth sentiment: since the end of September, they have risen 10%, even before the publication of the weaker-than-expected US inflation figure , yesterday, November 10. “We believe the main driver of the equity rally has been the perception of improving growth conditions, with the Atlanta Fed indicator pointing to a 600 basis point acceleration in US GDP growth since July: from -2% to +4%, even if the American Pmi index on new orders remains close to the lows of the cycle”, notes the BofA expert. This discrepancy, he explained, suggests that the volume of output (i.e. real GDP growth) has improved even though underlying demand (i.e. new orders) remains low, “most likely because companies are liquidating the backlog of orders accumulated during the Covid-19 pandemic”.
Raedler (BofA): Market growth expectations will be disappointed
Mr Raedler is convinced that market expectations for growth will be disappointed: if production can exceed underlying demand for a period of time, the lag that is fueling this overshoot will be eliminated, which should lead production to recouple. with underlying demand, bringing markets back in line with new Pmi orders. “We believe that the implied improvement in Pmi expected by the market is unlikely to materialize, as US growth is expected to slow due to the exhaustion of the credit cycle in response to the strongest monetary tightening in 40 years; Eurozone growth is expected to weaken further in response to the weakening credit cycle, even before factoring in headwinds from the energy crisis. Additionally, we see limited scope for a strong acceleration in growth in China, which is expected to gradually reopen, due to a still insufficient Covid vaccination campaign.”
Which sectors should be favored and which should be underweighted in the portfolio?
For all these reasons, the BofA strategist remains negative on European equities, underweighting cyclical stocks compared to defensive stocks. “We expect a further deceleration in growth to drag the market lower, offsetting the support provided by falling real bond yields on the back of a shift in central bank stance, shifting concerns linked to inflation to those linked to growth”, predicts the expert whose macroeconomic assumptions are consistent with a further 14% drop in the Stoxx 600 to 365 points in Q2 2023. “We continue to underweight cyclical stocks versus defensive stocks, given our forecasts of lower Eurozone PMIs, lower US 10-year bond yields and widening US high-yield credit spreads. Our favorite cyclical underweights are banks and auto stocks, while our favorite defensive overweights are pharmaceuticals and food & beverages. We are underweight value versus growth as we expect bond yields to decline.”
Citi: European earnings per share have peaked and will fall
Citi strategists are also cautious that European earnings per share (EPS) have peaked and are likely to fall in 2023. Earnings recessions in Europe have lasted an average of 21 months and earnings per share have fallen on average 35%. Analyst consensus still calls for 2% earnings per share growth in Europe in 2023, well above Citi’s top-down forecast of a 10% contraction. While Citi’s economists’ hard-landing scenario implies a decline in earnings of around 25%.
However, “we are entering this earnings-per-share contraction at a 15% discount to the long-term median, which should provide some protection,” Citi strategists said. “A 30% contraction in gross operating income would imply a 20% drop in prices from now on. The European equity market may have a better chance of decoupling from lower earnings in 2023, when inflation eases and bond yields fall.”
The lessons of history
Despite the reduction in the price/earnings multiple to 30 times at the start of 2000, the MSCI Europe index was still trading at 20 times when the earnings per share recession began in 2001. This offered little 40% eps impending drop protection. At the other extreme, European stocks entered the recessions of the 1970s and 1980s at very low multiples to limit the damage. Today, “we are entering this phase of a slowdown with not exaggerated valuations: the MSCI Europe price/earnings ratio is 13 times, while the long-term median is 15 times”, they indicate at Citi.
Citi moved diversified financials and chemicals from underweight to neutral.
Investment banking models suggest that current valuations of defensive sectors are already discounting average contractions in earnings per share. “Cyclical sectors such as energy, metals and mining or chemicals are already forecasting significant contractions in earnings per share, although history suggests the actual outcome could be worse. Growth sectors are vulnerable if earnings do not hold up,” Citi strategists said, raising their ratings on diversified financials and chemicals from “underweigt” to “neutral” as they expect a reassessment. In particular, “the chemicals sector has already fallen sharply this year and is entering a likely decline in earnings per share at discounted valuations”. ()