Bank of America: Are the two major positives about to disappear, and is the rise in European stocks just a "flash in the pan"?

Over the past decade, European stock markets have long been "living under the shadow" of record highs in US stocks, especially in US tech stocks. As we enter 2024, the situation in the European market seems to have undergone significant changes. The Euro Stoxx 50 index has hit a new high since 2001, with the Stoxx 600 index only less than 1% away from its historical peak. Major European stock markets such as Germany and France are also steadily approaching their historical highs.

Unlike the significant rise in European stocks, the European economy is still on the brink of recession. So, has the rise in European stocks deviated from the economic fundamentals? The debate among analysts in recent times has been whether there is a bubble in European stocks.

On February 16, led by Sebastian Raedler, a strategist at Bank of America, stated that the recent rise in European stocks is being driven by macroeconomic fundamentals rather than a bubble. The unexpectedly strong performance of the European economy, coupled with inflation slowing more than expected, has propelled the European stock market upwards.

However, the Bank of America strategist believes that these two factors will no longer exist in the future, and the upward trend in European stocks is about to reverse. By October 2024, the Euro Stoxx 600 index is expected to fall by more than 15% to 420 points. Against the backdrop of economic slowdown, defensive stocks are favored:

"We have to admit that recent macroeconomic data in Europe has been better than expected. However, the significant increase in interest rates by the European Central Bank will have a lagging effect, which is expected to impact economic growth a year and a half later. The momentum of economic growth may weaken in the coming months. If economic growth slows down, this may lead to an increase in risk premiums, and also imply a downward revision of corporate profit expectations. Although supply chain pressures have eased somewhat, inflation rates are lower than historical levels related to supply chain pressures, increasing the short-term risk of inflation rising."

The driving force behind the rise in European stock markets is about to "fizzle out."

Bank of America bluntly stated that the decline in European inflation, the unexpected escape from recession in the economy, and the dovish pricing of the European Central Bank have been driving the stock market higher. However, these factors may soon reverse:

"The hard data support brought by the backlog of orders after the epidemic has supported the stock market and earnings forecasts per share, keeping hard data relatively high compared to soft data. However, this is inconsistent with the weak demand in soft data such as PMI new orders. Due to the lagging impact of monetary tightening policies, credit conditions will continue to tighten, the support brought by the backlog of orders will weaken, further affecting the economy, putting pressure on the Eurozone composite PMI, which is expected to fall to 45 by the fourth quarter." Bank of America believes that although the current economic data is sufficient to keep the European stock market at a relatively low risk premium, as growth momentum weakens, this situation may not be sustainable. Future uncertainties and economic slowdown could negatively impact the stock market, leading to an increase in risk premium and a decrease in earnings per share. The stock market is expected to weaken again in the future, with the performance of cyclical stocks expected to be weaker than defensive stocks:

"We believe there is a risk of a rebound in European inflation, as inflation in the Eurozone is actually lower than its historical relationship with supply chain pressures (the best indicator historically to measure potential inflationary pressures) may lead to an inflation rebound.

The Eurozone economy is on the brink of recession, and if inflation fails to further decline, merely following the Fed's rate cut signal, a hasty turn by the European Central Bank could potentially lead to a sustained increase in inflation, undermining its efforts to stabilize prices.

We expect the 'perfect' pricing of European stocks to be disrupted by the weakening growth momentum, leading to a further increase in risk premium and a decline in EPS expectations. This will cause the Stoxx Europe 600 index to fall to 420 in October (a drop of over 16% from current levels).

Compared to defensive stocks, we have a negative view on cyclical stocks and expect the performance of cyclical stocks to be 10% worse than defensive stocks by October. We prefer to overweight defensive industries such as food & beverage and pharmaceuticals, while underweighting cyclical industries such as banks and automobiles."