Welcome to Thoughts on the Market. I'm Graham Secker, head of Morgan Stanley's European and UK Equity Strategy team. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about our latest thoughts on European equities and why we are not concerned about their recent underperformance versus the U.S. It's Monday, July the 12th, at 2:00 p.m. in London.
After performing strongly for much of this year, European stocks have traded sideways over the last month, underperforming the U.S. but still outperforming EM and Japan. However, this recent underperformance vs. U.S. stocks is causing some investors to question whether the best of Europe's run is now behind us. We think not, and remain optimistic for the remainder of the year.
A key part of our argument is the observation that the underlying fundamentals behind the European equity market remains strong, with the region currently seeing a faster pace of earning upgrades than anywhere else. From an economic perspective, the data also continues to come in better than expected, with the Eurozone enjoying the best economic surprise index of any major global country or region. Most eye-catching of all the recent data releases, is arguably the European Commission's economic sentiment indicator. This rose to its second highest level in June, and this is based on data going back 35 years. Interestingly, the latest reading was boosted by a strong bounce in both the consumer and services components that have previously lagged, suggesting that the optimism is high across all parts of the economy and not just manufacturing.
Fitting with the strong macro data coming out of the region, Eurozone inflation expectations have remained towards the top of their recent range and have not followed the drop we've seen in the U.S. since the last Federal Reserve meeting in mid-June. Against this backdrop, we think it is hard to argue that the recent underperformance of European equities is due to fundamental growth concerns. Instead, we think it is down to a partial unwind of the global reflation trade, post this last Fed meeting - the date of which triggered the start of this period of European vs. U.S. stock underperformance.
In particular, the recent fall in U.S. bond yields has taken many people by surprise and undermined the reflationary narrative that had previously been boosting cyclical companies and those stocks with more of a value bias - both areas where Europe has a higher representation than peers. While this uncertainty may persist for a little longer through the summer, we expect investor confidence to recover as we move towards the latter stages of the year, helped by a continuation of healthy economic data and higher bond yields. Our U.S. bond strategists expect U.S. 10-year yields to end the year much higher than they are today, at 1.8%.
As yields rebound, we'd expect European equity outperformance to return and note that the level of global investor engagement with the region remains high. In addition, we are also seeing a sharp acceleration in mergers & acquisitions, most noticeably in the UK, where activity is running at double the pace seen in the U.S. and the rest of Europe. One catalyst here is likely to be the UK equity market's very low starting valuation. The UK is the only major world stock market where valuations are below their 10-year average – whereas they remain close to decade highs in all other regions.
Bottom line, we are not concerned about the recent pause in Europe's outperformance and remain optimistic about opportunities for the remainder of the year.
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