Too Far, Too Fast? Strategists Expect European Stocks To Tumble By Year-End

Equity strategists are cooling on the prospects for further gains in European stocks just as investors poured a record amount of money into the region’s equity funds...

After a French election victory for centrist Emmanuel Macron and analysts suggesting that optimism over better profits is largely priced in, forecasters now see fewer triggers for the rally to continue in 2017.

Equity strategists, “having been torched for their prior optimism in the past, might be cautious in continuing to call Europe up after a very good run,” saidMichael Ingram, a market strategist at BGC Partners in London.

“It’s difficult to identify any near-term catalysts for continued outperformance as most of the political tripwires appear to have been negotiated, easy monetary policy is priced in and the European earnings season is essentially done.”

As Bloomberg reports, the Euro Stoxx 50 Index of the biggest euro-area stocks will finish the year at 3,498, 3.8 percent lower than Friday’s close, according to the average in asurvey of 15 banks compiled by Bloomberg. For the Stoxx 600, nine banks expect the gauge to end the year 2.4 percent lower than Friday’s level, a mean of their predictions shows.

Goldman: "The Last Time Correlations Were This Low Was Just Before The Financial Crisis"

In a note from Goldman"s cross-asset strategist Ian Wright, the bank points out something troubling: on one hand, over the past six months, or rather since the US elections, equity markets around the globe have soared, and returns across regions have been "strong" - S&P 500, Stoxx 600, Nikkei 225 and MSCI EM ($) have returned roughly 11%, 16%, 20% and 11% in local currency price terms, respectively, with MSCI World ($) up 12% over the same period.  In other words, everything is up. And yet, while equity indices have rallied across regions, inter-regional equity return correlations have actually fallen materially to their lowest levels since 2000.

Why is this troubling? Because as Wright casually throws out, "the last time correlations were this low was in 2007, just preceding the financial crisis"

So does this imply that a financial crisis is imminent? Goldman isn"t sure, and notes that the collapse in correlations "leads to the questions whether we expect correlations to remain low or whether we expect equity markets to recouple and move more in lock step, and what the environment will be from here. In our asset allocation, we are overweight Asian and European equities and underweight US equities over both 3- and 12-month views, with the former on growth expectations inflecting and an earlier cyclical position supporting EM and EAFE while, in the latter, the expectation that higher valuations and the later cycle of the US weigh on returns (see Exhibit 2 for return forecasts).

And just to hedge its bets, and not upset too many clients, Goldman even provides a bullish spin on the data: As Wright adds, "Exhibit 9 shows that while inter-regional equity correlations have indeed come down on average, they have remained more elevated between non-US markets such as Europe and Japan. We would not be surprised to see this trend continue in the absence of growth shocks and with anchored volatility, with the US the lagging performer from here. Data based on May 5, 2017 market close."

Which will be right outcome: collapsing volatility as a precursor to another crash, or a catalyst for even more gains? Look to this week"s barrage of Fed speakers for the (rhetorical) answer.

"The European 'Story' Is Broken"

Via Ben Hunt of Salient Partners" Epsilon Theory blog,

George Soros has a great line, one that I’ve stolen many times: “I’m not predicting. I’m observing.” We really don’t have a crystal ball, and it really is a dumb idea to pretend that we do. But what’s not dumb is to keep your eyes and ears open, observing both what the world is telling you (playing the cards) and what other market participants are telling you (playing the players), and reacting accordingly. That’s the heart of tactical investing.

What I’m observing today is that the European *story* is broken. I’m not saying that real world European companies are broken or that real world European economies are broken. In both cases, a few are but most aren’t. What I’m saying is that the buy-Europe!™ story that has been pitched by the sell-side ad nauseam for the past six months is broken and that these stocks are defenseless against the steady stream of anti-Europe political news we are going to endure for the next eight weeks.

Here’s the S&P 500 Index (“SPX”) in black, German DAX Index (“DAX”) in green, and Stoxx 600 Index in red over the past six months:

Source: Bloomberg, as of 02/26/17. For illustrative purposes only. Past performance is not indicative of how the index will perform in the future. The index reflects the reinvestment of dividends and income and does not reflect deductions for fees, expenses or taxes. The indices are unmanaged and are not available for direct investment.

Yes, the DAX has outperformed the SPX over the past six months. Why? Because every sell-side strategist and his cousin has been pounding the table that Europe is recovering and Europe is cheap and why worry about all those elections, anyway, because even if Le Pen wins it’ll just be like Brexit and everything will be fine.

The truth is I don’t know whether or not Le Pen will win in France this May. I don’t have a crystal ball. But what I do know is that nothing is happening between now and those elections that makes it less than a 50/50 coin toss whether Le Pen wins. There’s going to be a steady stream of negative press about all of the candidates from now until then, the difference being that core Le Pen supporters, like core Trump supporters, don’t care about the negative press. There is no story that could make these stocks go UP, but there will be plenty of stories that can make these stocks go DOWN.

And yes, I know that for “patient, long-term investors” and all the Warren Buffett wannabes out there, what happens over the next eight weeks doesn’t matter a bit, and if European stocks go down it just means that they’re even more “on sale”. But what I also know is that whenever I read a sell-side note talking about why something is a buy *today* for “patient, long-term investors”, that’s typically a signal to start shorting whatever they’re pitching. What I also know is that it’s a lot easier to be Warren Buffett when you’ve got $100 BILLION in more-or-less permanent capital from your insurance float. Good for him. Ain’t my situation. I’m guessing it isn’t yours, either.

But the risk here isn’t just a temporary blip on the European horizon. Here’s a picture of 2-yr French bond yields to 2-yr German bond yields (yellow), 2-yr Italian bond yields to Germany (red), and 2-yr Spanish bond yields to Germany (green) over the past six months. If you lived through the summer of 2011, this chart should give you a shiver.

Source: Bloomberg, as of 02/26/17. For illustrative purposes only. Past performance does not guarantee future results.

This is telling you that bond markets are starting to get really nervous about Europe and the stability of the Euro system, and the time frame of their nervousness is over the next two years. Could all this blow over if we get a market-friendly political result in May? Absolutely. And if that happens, maybe I’ll buy Europe THEN. 

But until then, I’ll listen to what the bond market is telling me over whatever Goldman Sachs and Morgan Stanley and the rest of our sell-side friends is pitching me. I’m not predicting. I’m observing.