Europe’s second wave

Restrictions on mobility come with a significant economic cost

Sebastian Raedler (BofA Global Research) | Europe’s virus resurgence weighs on growth momentum: a sharp rise in virus cases has dampened European growth momentum, with the Euro area composite PMI new orders declining from a peak of 53 in July to 50 in September, following the sharp rebound from a trough of 14 in April. Weaker domestic growth momentum, in combination with uncertainty on US fiscal stimulus and rising real bond yields, has led the Stoxx 600 to decline by 5% over the past week to a two-month low of 355.

We remain positioned for recovery, but downside risks have increased: the key question is if growth momentum has peaked and, hence, if investors should rotate away from the cyclical beneficiaries of the macro recovery and into defensive hiding places. We think it makes sense to stay positioned for continued recovery and further cyclical outperformance, but the argument has become more balanced.

On the negative side: (1) containment measures could further dampen service sector activity; (2) Q3 was likely the point of maximum macro acceleration, so renewed PMI upside will have to be achieved against the backdrop of a fade in Euro area IP momentum and GDP growth from their Q3 peak levels; and (3) Brexit risks have risen, with a possible no-deal Brexit potentially starting to weigh on growth in the months ahead.

On the positive side: (1) we see scope for the European Covid-19 case count to start declining over the coming weeks, helping the Euro area PMI to recover; (2) hospitalizations and deaths remain subdued in Europe, reducing the pressure on policymakers to react with harsh containment measures; (3) economic activity has rebounded strongly from its early-Q2 trough, but this has not yet been reflected in PMIs. Our economists’ Euro area Q4 GDP forecast implies renewed PMI upside over the coming months; and (4) the external growth backdrop is supportive, with the US PMI set to remain close to the current recovery high of 55.

We expect renewed upside for European equities and cyclical versus defensives: we expect European virus cases to start fading over the coming months, leading to a partial reversal of containment measures. This should allow the Euro area PMI to rebound, although we now see downside risks to our projection of a PMI at 58 by Q4. Our macro assumptions imply a renewed 15% rise for European equities and 10% outperformance for cyclicals versus defensives. We expect a maturing global recovery to translate into rising bond yields, boosting financials and value versus growth stocks, while weighing on pharma and utilities.