European Economic Growth Expectations Face Reality Check

A Wave of Optimism

European markets have recently experienced a surge of optimism, fueling an expected economic improvement that has boosted stocks. However, this anticipated growth now needs to materialize. Despite the ongoing uptrend for the Stoxx 600, signs of market overheating have emerged, particularly as investors' optimism exceeds the actual economic data. The upcoming release of European preliminary PMIs may provide further insight into the growth outlook, especially considering the uncertain trajectory of monetary policy.

Manufacturing PMIs and Cyclical Equities

Over the past few months, stalling manufacturing PMIs have coincided with a noticeable fluctuation in cyclical equities relative to defensives. Without significant improvement in the data, a similar pattern could emerge, given the wide gap with stocks. UBS strategists Gerry Fowler and Sutanya Chedda advocate for high-quality exposure over cyclicals, suggesting that while the data doesn't yet indicate impending stagflation, markets may be underestimating this possibility.

Performance of Cyclical Equities

Cyclical equities have significantly outperformed, largely due to earnings delivery and bottoming economic data. However, the situation appears to be reaching its limit. Cyclical equities have risen by 30% since the end of October, more than double the returns of defensives and surpassing the Stoxx 600's 20% surge. The first quarter earnings season has begun to reveal potential weaknesses in the bullish case.

Concerns About Earnings Prospects

JPMorgan strategists led by Mislav Matejka note a softening in cyclical sector earnings compared to defensives, with median cyclical versus defensives EPS growth for the Stoxx 600 at -15%, the worst since the second quarter of 2020. They expressed concerns about the earnings prospects of carmakers due to pricing, volumes, and margin weakness. They suggest that while European activity momentum is improving compared to last year, it remains weak in a historical context, and margin pressures could emerge.

European Market Performance

Despite Europe being a more cyclical market than the US, it doesn't necessarily need a cyclical boost to perform well. The recent performance of the overall stock market has shown a clear broadening, reflecting the uncertainty surrounding the economic outlook and monetary policy. Barclays strategists led by Emmanuel Cau believe that the growth/policy mix in Europe is becoming more favorable, with green shoots appearing in the economy and upcoming ECB/BOE cuts potentially creating opportunities within the market.

Technical Analysis

From a technical standpoint, the current consolidation phase isn't yet a cause for concern. DayByDay technical analyst Valerie Gastaldy notes that the Stoxx 600 has opened three gaps on the way up to 525.2. She suggests that a drop to 514 would not significantly impact the trend. However, if prices fall below this level, it could indicate that the index is correcting either the trend started in January or the one initiated at the end of October.

Final Thoughts

As European markets face a reality check, it's clear that the optimism that has fueled growth expectations needs to be met with actual economic improvement. This situation raises some thought-provoking questions. How will the markets react if the anticipated growth fails to materialize? What strategies should investors adopt in the face of this uncertainty? We encourage you to share your thoughts and this article with your friends. Also, don't forget to sign up for the Daily Briefing, which is delivered every day at 6pm.