Stagflation Could Endanger Any Rebound In Europe

Stagflation Could Endanger Any Rebound In Europe
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As European stocks nurse their first monthly decline in three, there’s one risk that could cast a shadow over prospects for a year-end rebound: stagflation.

While investors have cheered signs of slowing inflation and a resilient economy in the US, the picture in Europe remains more challenging. Figures this week are expected to show core inflation in the euro area only dipped a touch in August, at a time when a contraction in private-sector activity has unexpectedly worsened.

Add in the downbeat recovery in China — a big market for sectors such as mining, luxury goods and autos — and there are few takers for regional stocks, even with valuations near a record low relative to US peers.

“Cheap is just one criterion for whether something is an attractive investment,” says Andrew Bell, chief executive officer of Witan Investment Trust, whose overweight on the region reflects the appeal of individual quality stocks. “European growth is going to remain in a longer-term declining trend compared with the US and emerging markets, and if a broad-based rally in Europe lifts valuations, that could see more investors shift to emerging markets.”

The impact of weaker growth is already showing up in the performance of sectors whose fortunes are most closely linked to the economy. After beating defensive stocks until early-August, the so-called cyclical sectors have fallen behind in the past few weeks. JPMorgan strategists expect the underperformance to worsen as they don’t see a “meaningful recovery” in business activity in the near term.

Autos, capital goods, retail, chemicals, banks, semiconductors and travel and leisure stocks are particularly at risk, the JPMorgan team led by Mislav Matejka says, as they also miss out on a boost from a recent surge in bond yields. Typically, higher yields correlate with a rally in cyclical sectors, but this time around the move has been driven by “the wrong reasons” — a downgrade of US government debt by Fitch Ratings and lower demand for bonds, rather than just receding calls for an American recession, according to Matejka.

For cross-asset investors, bonds are proving to be more attractive than stocks as real yields rise given “investors’ impatience” for core inflation to cool as quickly as overall price pressures, Deutsche Bank strategists say. US Treasuries have now recorded inflows for 28 straight weeks — the longest streak since 2010, according to a note from Bank of America citing EPFR Global data. By contrast, money has exited European stock funds for 24 weeks in a row.

The Deutsche Bank team including Maximilian Uleer and Carolin Raab says the move in German bunds presents “an interesting entry point” as the current yield is already above their rates strategists’ target for 2023. “We expect bunds to be negatively correlated to equities and to offer a positive real yield,” they say.

That move could prompt European stocks to fall further behind their US peers into the year end. The Stoxx 600 has now underperformed the S&P 500 for four straight months in dollar terms — erasing a lead from earlier this year — and market strategists don’t expect any further gains in the European index for the rest of 2023.

Morgan Stanley’s Graham Secker also has a bearish view on the outlook for European stocks as he says optimism around a soft landing is overdone. He expects weak macro data to lead to earnings downgrades through the rest of 2023, while stocks suffer from the “unusual double whammy of (much) higher rates and (much) tighter credit conditions.”

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