The Factory Daily Letter

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Can Europe play catch up?

We think there are several reasons why European cyclicals could benefit from a bounce

Equity markets have been having a tough time of it this year, and continue to face multiple headwinds: Fed policy tightening (markets continue to price an aggressive rate hike trajectory), inflation (disappointing April CPI print) persistent supply-chain bottlenecks, slowing global growth (China and Zero Covid) and of course war in Ukraine are among the many issues that continue to weigh on investor sentiment. The S&P 500 is down 15.9% while the STOXX Europe 600 has retraced nearly 11.1% as we write.

This as the economic momentum continues to show evidence of deterioration in both regions. Neither regional index is in a bear market yet (unlike the unfortunate Nasdaq composite which is currently down 25.5% year-to-date). Talk of stagflation or even recession risk has been growing in the US as investors weigh up whether the Fed can pull off a so-called ‘soft landing’ in its efforts to bring down inflation while not stalling the economy, while in Europe investors primarily have their eyes on the fallout from the ongoing war in Ukraine.

On the economy front, US GDP annualized growth fell 1.4% over Q1 2022; while in Germany growth was relatively flat over the same period (+0.2% QoQ). In the US (and as we highlighted in our latest Technical View in which we focused on the Friday 13th equity market rebound), the unexpected decline in the US Empire Manufacturing survey index in May as released Monday nonetheless suggests further expected decline ahead for manufacturing activity. But slowing growth may nonetheless prevent the Fed from pursuing a rate-tightening trajectory that is as long and steep as the market currently sees it. Moreover, from a historical perspective, never has the Fed hiked rates when the US economic activity has been decelerating.

Both US and European equity markets are down since the beginning of the year, but European markets have been relatively resilient since mid-March

Following Russia’s invasion of Ukraine on 24 February, we saw a period during which European equities as a whole underperformed their US peers. The STOXX Europe 600 reached a local low on 8 March as investors priced the worst-case scenarios around conflict escalation as well as the associated pressure on food and energy prices and lower growth. Then in mid-March they rebounded, catching up with the US market, before outperforming it in April.

There are several factors that go some way to explaining this:

  • Robust earnings: First, and as per our recent letter on the European earnings season, European companies have posted robust earnings while management teams still appear relatively confident despite the challenging environment;
  • Policy differential: While markets are now speculating around a first rate hike from the ECB as soon as July, we think it unlikely to be as hawkish as the Fed, especially given the prevailing economic headwinds and the ongoing war in Ukraine;
  • A weaker euro: The sentiment and monetary policy differential between the Eurozone and the US has sent the euro close to a 6-year low against the US dollar. Historically this has tended to deliver European stocks a tailwind, as many of European companies tend to be more export-dependent;
  • Extreme sentiment: Bearish sentiment have reached such extremes that from a contrarian perspective entry opportunities are become enticing. Accordingly, any good news could result in short-term rebounds. An example is how Q1 Eurozone GDP growth (second preliminary) that released higher than the first estimate (0.3% QoQ vs 0.2% for the preliminary reading) fueled a risk-on trading session Tuesday that sent European equities higher – the European market also more cyclical than its US peer;
  • China: News from China that Shanghai had reported a third straight day without any reported Covid infections (and that accordingly the authorities may start to ease restrictions) is welcome. Policymakers have also been announcing more economic support including a 20 basis-point rate cut applicable to new mortgages and more credit support to some private property developers. The reopening of the Chinese economy could prove a short-term tailwind for European stocks that remain heavily exposed to the Asian Giant’s economy;
  • Index composition: Finally, US stocks remain largely growth-oriented and therefore the market tends to suffer more than its European peer – which is more value-titled – when rates are rising;

So read on for more detail on why we think we could see a short-term rebound in equities – and moreover why we might prefer Europe.

1. What is currently priced?

As distinct from the US, it appears that Europe may have already priced the deteriorating economic outlook. This is illustrated by the graphs below - which depict crudely how the S&P 500 and the Dax indices have been tracking economic activity in their respective regions (using the ISM new orders index and the European manufacturing PMI respectively as proxies). The S&P 500’s annual return appears to be tracking current activity, while a large gap has opened up between the Dax (down 11.4% YoY) and the European manufacturing gauge. This suggests that any small improvement in sentiment (or indeed economic data) could now trigger a sharp (if tactical) rebound in European cyclical stocks:

Source: FactSet; Pictet Trading Strategy; as of 16/5/2022.

2. Has the European cyclical / defensive ratio overshot fundamentals?

A similar conclusion can be drawn when we look at the evolution of the cyclical vs defensive industry index performance ratios for the two regions and how they are tracking their respective activity proxies.

The performance ratio has been moving lower in the US yet it is still in line with the deterioration in the ISM manufacturing PMI gauge, while in Europe cyclical underperformance appears to have over-shot fundamentals on this basis. Again while this may reflect market expectations of further economic slowdown in Europe, it also suggests that any small improvement could also lead to a sharp rebound in cyclical stocks:

Source: FactSet; Pictet Trading Strategy; as of 16/5/2022.

3. EPS revisions have been stronger in Europe than in the US

This year’s disappointing equity price action has been driven mainly by rising yields and geopolitical tensions which have overshadowed the ongoing evidence of resilience on the part of listed corporations. This is particularly the case in Europe. Since the beginning of the year, companies have reassured with good hedging of input costs and accordingly 2022 EPS has been revised up by 9.4% in Europe and by 2.6% in the US – the trend accelerating further in Europe since the beginning of the earnings season.

Source: FactSet; Pictet Trading Strategy; as of 16/5/2022.

This has triggered a rebound in earnings sentiment as reflected in the chart below which tracks number of positive revisions to negative revisions for a number of global regions. Europe is the only one so far to show a reversal in earnings sentiment:

Source: FactSet; Pictet Trading Strategy; as of 16/5/2022.

4. European stocks tend to benefit from a lower Euro

The Stoxx 600's greater exposure to the classic “reflation” sectors (such as energy and materials) has been a key driver of market EPS revisions. But the depreciation of the euro against the US dollar has also been a key tailwind.

As illustrated below, the analyst sentiment differential between the Europe and the US tends to follow the EURUSD pair, with European equities tending to capture more upgrades than the US when the euro is weaker. So it is that the weakening Euro we have witnessed over the past six months could support into the next quarter:

Source: FactSet; Pictet Trading Strategy; as of 16/5/2022.

The greenback also remains a safe-haven asset

As we discussed in our recent letter Capitulation contagion: dissecting the market malaise, much of the dollar's appreciation can be chalked up to the flight to safe-havens as a consequence of the high uncertainty, while the Fed’s shift to tightening rate policy / normalization has also supported the dollar against the euro. As you can see from the long-term technical chart below, the EURUSD pair recently broke below a 40-year support, implying that the negative trend could continue further:

Source: FactSet; Pictet Trading Strategy; as of 16/5/2022. *Criteria are explained in the endnotes. The target price presented in the chart is based upon chart analysis. This is not the product of any Pictet financial research unit.

5. Valuation

Relative valuation shows that Europe is now trading at a 27% discount to the US, which is one of the most attractive levels it has seen over the past 20 years. Over the past year, the Stoxx 600 has suffered from a 23.5% PE contraction versus only 18.9% for the US, while both display the same performance (around -3.5%). As shown previously, Europe no longer appears expensive while in the US valuations still appear extreme. Given the negative earnings revision differential and the market's greater exposure to fast growing companies, the US could be more at risk of further valuation compression:

Source: FactSet; Pictet Trading Strategy; as of 16/5/2022.

Every major regional index has suffered PE contraction this year. Europe is trading at a current PE ratio of 12.9 (down from 15.9 in 2021) which places the current valuation in the 45 percentile if we look at a 20-year historical range. By way of comparison, the US, EM and “World” are still trading at close to historical highs despite deratings:

Source: FactSet; Pictet Trading Strategy; as of 16/5/2022.

6. Any small improvement in investor sentiment could prompt further outperformance on the part of European equities

While investors remain relatively risk averse, our own risk-on risk-off indicator has recently rebounded from extreme risk-off territory. This is a sign that market participants might be willing to take on more risk in the days to come. As shown in the bottom chart of the two below, extreme risk-off levels have usually been followed by positive returns for European equities. It appears this move may have already begun - but still may have further to go should risk appetite continue to normalise:

Source: FactSet; Pictet Trading Strategy; as of 16/5/2022.

7. The technical view

From a long-term technical perspective, the STOXX Europe 600 has been evolving in a 170 – 400 range since 1996. Over the last eight years, the European benchmark has been trading in the upper part of its historical channel while forming a bullish “megaphone” pattern (characterized by three higher highs and three lower lows).

In 2020, the index found support at around 320 following the Covid-induced crash, before rebounding sharply - firstly above its long-term resistance at around 400, before heading towards its historical top at 490. More recently, the index lost momentum and is set to find support over its former rising resistant of the megaphone pattern at around 425. This level may offer an entry opportunity in our view.

Source: FactSet; Pictet Trading Strategy; as of 16/5/2022. *Criteria are explained in the endnotes. The target price presented in the chart is based upon chart analysis. This is not the product of any Pictet financial research unit.

Short-term, the index formed a bullish high last week at around 420 before rebounding. Key resistance is around 455: the falling resistance line connecting the year-to-date highs:

Source: FactSet; Pictet Trading Strategy; as of 16/5/2022. *Criteria are explained in the endnotes. The target price presented in the chart is based upon chart analysis. This is not the product of any Pictet financial research unit.

Stock screening: European cyclicals

Despite the ongoing war in Ukraine, the prevailing concern about persistent higher inflation, and the prospect of policy tightening, the extremely negative level of investor sentiment could present – from a contrarian perspective – a short-term opportunity to position for a rebound in European stocks. Any small improvement in the news flow or the data (a slightly less-hawkish Fed, a potential ceasefire in Ukraine or more encouraging evidence of peaking/slowing inflation for instance) could allow equities a reprive from the downward pressure, and European companies seem more attractive should this scenario materialize.

On the basis of our view that European cyclicals in particular stand to benefit from a short-term rebound, we present below a screening of better-quality European cyclical stocks ranked by global grade:

Source: FactSet; Markit, Copyright © 2022 S&P Global Market Intelligence; Pictet Trading Strategy; as of 16/5/2022. *Criteria are explained in the endnotes. The target price presented in the chart is based upon chart analysis. This is not the product of a

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