Graham Secker: A Moment of Calm for European Equities

Amid uncertainty in the global banking sector, are European equities a safe haven for investors to weather the storm?

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Welcome to Thoughts on the Market. I'm Graham Secker, Head of Morgan Stanley's European Equity Strategy Team. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about the implications on European equities from the increased uncertainty surrounding the global banking sector. It's Tuesday, March 28th at 3 p.m. in London. 

After the turbulence of mid-March, a degree of calm has descended over markets recently, which has lifted European equities back to within 3% of their prior high and pushed equity volatility down to more normal levels. In effect, we think investors are now in 'wait and see' mode as they try to assess the forthcoming consequences and investment implications of recent events within the global banking sector. 

Our recent discussions with investors suggests a potential lack of willingness to get too bearish at this time, with some still hopeful the markets can navigate a path of modestly weaker growth, with lower inflation and less hawkish central banks. For us, we view this outcome as a possibility rather than a probability and reflective of the fact that investors have been positively surprised by the general resilience of economies and equity markets to date. 

However, this viewpoint ignores the fact that something has changed in the overall macro environment. First, yield curves are starting to steepen from very inverted levels, a backdrop that has traditionally been negative for risk markets as it reflects lower interest rate expectations due to rising recession risk. And second, we now have clear evidence, we think, that tighter monetary policy is beginning to bite. 

Over the coming weeks, we may see anecdotal stories emerge of problems around credit availability, followed thereafter by weaker economic data and ultimately lower earnings estimates. We also suspect that more financial problems or accidents will emerge over the coming months as a result of the combination of higher interest rates and lower credit availability. These issues may not necessarily manifest themselves in the mainstream European banking sector this time, however asset markets will still be vulnerable if risks emerge from other areas such as U.S. banks, commercial real estate or other financial entities. 

As a result of this increased uncertainty, we have taken a more cautious view on European equities in the near-term and forecast the region's prior outperformance of U.S. stocks to pause for a while. Within the European market, we see a trickier outlook for banks, given crowded positioning and less upside risk to earnings estimates than previously thought. However, the area of greatest caution for us is cyclicals, with the group most exposed to rising recession risk and weaker equity markets, and we are particularly cautious on those sectors most sensitive to credit dynamics such as autos. 

On the more positive side, we continue to like longer duration sectors such as luxury goods and technology, and believe they will continue to act as safe havens while market uncertainty remains high. In addition, we think the telecom sector offers an attractive mix of low valuation, healthy earnings resilience and the potential for more corporate activity and increased policy support from regulators going forward.  

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