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, pharma‘s 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.
