Turning tactically neutral on European equities

BofA | We turn tactically neutral on European equities: We lower our weighting on European equities from positive to neutral following the 14% rally since August. Our macro projections remain unchanged: we expect a further 1.5 points upside for the Euro area composite PMI new orders to 52 by February, following the 2-point rise since September.

However, we note that:

(a) much of the good news is in the price, with the Stoxx 600, at 418, 4% above the fair-value level implied by our analysis, based on the Euro area PMI, the EUR, the Euro area real bond yield, the EU policy uncertainty index and the oil price;

(b) our macro projections are consistent with a Stoxx 600 range of 390 to 430 over the coming six months (implying up to 6% downside near-term, followed by 3% upside);

(c) our projections assume a continued fade in political uncertainty from still-elevated levels, given the positive developments around the US / China trade war and Brexit, but rising US / Iran tensions could challenge this assumption;

and (d) we expect mild downside for real bond yields i.e. the discount rate for equities over the coming months, but the recent overshoot in Euro area core inflation to 1.3% points to upside risks for real bond yields relative to our base case. We maintain a small overweight in European cyclicals versus defensives, with our macro assumptions implying 7% upside for cyclicals price relative by mid-Q2.

Key recommendations:

(1) Underweight pharma: while a number of defensive sectors have underperformed in the recent cyclical rally, pharmas price relative remains close to its peak and 4% above the level implied by US bond yields and the USD. Our assumptions of further near-term upside for US bond yields and mild USD downside imply 11% underperformance for pharma by end-Q1;

(2) Overweight food & beverages: the sector has sharply undershot its relationship with US bond yields. Even our base case assumption of a further mild rise in yields would be consistent with 11% outperformance by late Q1;

(3) Overweight capital goods: our projections for further Euro area PMI upside points to around 5% upside by mid-Q2, leading us to raise the sector from marketweight to overweight;

(4) Underweight airlines: the sector has underperformed the market by 10% since mid-December. Our assumptions of mild Euro area PMI upside and the oil price remaining broadly at current levels is consistent with a further 15% underperformance over the coming months;

(5) Underweight value vs growth: European value stocks have underperformed growth stocks by 3% since October. Our projections for value vs growth are based on our analyses for banks and energy (the largest value sectors) as well as food & beverages (the largest growth sector). Our sector projections are consistent with a further 4% underperformance for value vs growth by end-Q1.