European Equities: Growth up, uncertainty down, but further market upside is limited

European equities

Growth up, uncertainty down, but further market upside is limited: Surveys showed an improvement in global growth momentum in October and the Global Policy Uncertainty Index is likely to have continued fading from the all-time high it reached in August. But after the recent rally, much of the good news is already priced into markets. We remain positive on European equities, but note that the market is already 4% above the current fair-value implied by our Stoxx 600 analysis and only has 5% further upside to our target of 425 by mid-March. We maintain a small overweight of cyclicals versus defensives, but continue to reduce our cyclical exposure by reducing airlines from overweight to marketweight.

European cyclicals versus defensives are starting to look stretched: European cyclicals have outperformed defensives by 10% since early September, overshooting the fair-value implied by our analysis, based on the Euro area PMI, US bond yields and FX. Our assumptions for these macro drivers imply 5%+ near-term downside for cyclicals versus defensives, followed by renewed upside from late Q1 onwards. We are underweight a number of cyclical sectors that look particularly stretched (autos, construction materials & luxury goods). We see the best opportunity for further upside in the resources sectors as well as the bond proxies that have sharply undershot the fair-value levels implied by their historical relationship with bond yields (European food & beverage and personal & household goods).

We remain overweight European resources: Mining and energy had, until recently, not participated in the cyclical rally, as oil and copper continued undershooting the fair values implied by our analysis. Over the past weeks, however, mining has outperformed the market by 8% and energy by 2%, as a weaker USD helped copper and oil rise by 5%+. Mining and energy are the largest overweights in our sector portfolio, given that we expect fading global policy uncertainty to continue weighing on the USD, implying upside for commodity prices. Our macro assumptions point to 15% potential upside for mining’s price relative and 11% for energy’s price relative by year-end.

We lower European airlines from overweight to marketweight: Airlines’ relative performance tends to move in line with Euro area PMI momentum, with the over- and undershoots explained by moves in the oil price. We introduced our overweight in airlines in September after sharp underperformance earlier this year had left the sector priced for an outright Euro area recession. The sector subsequently outperformed the market, closing the gap to the macro-implied fair-value. We now lower airlines from overweight to marketweight, as we expect a rising oil price to drag on airlines’ performance over the coming months.