European stocks are the ” flavor of the month.” But it won’t take much to “sour” investor sentiment again, Bloomberg notes.
With a 10% rise in January, eurozone stocks are outperforming the US and enjoying their best start to a year. But top investors, such as Black Rock and Amundi, warn that markets are too optimistic about the risks ahead.
A lot can derail this rally. Earnings downgrades are accelerating, with the European Central Bank sticking to its” hawkish ” stance in the face of recession as inflation – although easing – remains elevated. And there is no solution in sight to the war in Ukraine that began almost a year ago.
“It’s dangerous to think that because stocks are going up, things are OK,” said Casper Elmgreen, head of equities at Amundi. “We now have very high confidence that the resilience of 2022 will be broken. The market has yet to assess the magnitude of the impending earnings downgrades.”
Lower energy prices, signs of falling inflation and an acceleration of China’s reopening have boosted sentiment, with the Euro Stoxx 50 index up 27 percent from its September low. Cash is also starting to return to European equity funds after nearly a year of acquisitions.
But leading asset managers remain cautious, and trading data suggests the gains so far have been due to short-liners covering positions. Strategic analysts at the Black Rock Investment Institute said optimism about the stock market came too early, while analysts at Goldman Sachs Group and Bank of America warn that the best part of the 2023 rally may already be over.
Here are the five main risks that could send European shares into a slump:
War in Ukraine
Russia’s control of gas supplies to Europe continues to threaten economic growth. While a milder winter has helped the region avoid an energy crisis this time, more political intervention may be needed if Russia stops the supply.
Nearly a year after the weeks-long invasion, Vladimir Putin is preparing a new offensive in Ukraine, while the U.S. and Germany are sending tanks into Ukraine in a broad allied effort to equip the country with more powerful weapons. The moves signal the potential for an escalation of the war.
The energy war “could go on for a long time,” said Anaka Gupta, Director of Wisdom tree UK. “As we cannot always rely on favorable weather conditions, measures such as strengthening gas reserves and sharing energy demand should continue.”
Pain in Earnings
Analysts have cut earnings forecasts ahead of the reporting period, with some strategic analysts calling for even deeper cuts against the backdrop of slowing growth. With inflation easing, companies are also finding it difficult to raise prices at a time when demand is slowing.
In terms of credit, the combination of persistent inflation and higher interest rates is going to weigh on many companies ‘ liquidity position as profit margins shrink and servicing their debt becomes more expensive.
Early indications from the reporting period suggest there is cause for concern across all industries. Retail firm Hennas & Maurits said soaring costs nearly wiped out profits in the latest quarter, wind turbine maker Vestas Wind Systems A / s warned of another blow to sales this year, while software maker SAP SE plans job cuts in a bid to boost its profits.Bottom-up analysts are predicting solid earnings growth in Europe this year. Top-down market strategists take a gloomier view, with those at Goldman Sachs, UBS Group AG and Bank of America expecting a fall in earnings of between 5% and 10%, signalling further share losses as valuations cap lower forecasts.
Wrong Policy
The latest signals from ECB policymakers suggest they will stay on course to raise interest rates until they see a more significant retreat in inflationary pressures. But equity investors are optimistic about a soft landing of the economy and rate cuts later this year.
This discrepancy has seen equities move in sync with bonds – where investors focus on a recession – and could lead to a fall in equities if the ECB stays on a “hawkish” path for longer.
“This is one of the areas where the market is overly optimistic,” said Hoakim Clement, Liberum Capital’s head of strategy, accounting and sustainability. Rising inflation through 2023 means policymakers will have ” little to no room to cut interest rates even in the event of a recession. If central banks do not want to repeat the mistakes of the 1970s, they will have to wait until inflation is close to 3%, which we do not expect before 2024.”
Some economists, including Goldman Sachs, say the euro zone could avoid recession altogether this year, citing signs of resilient economic growth and averting an energy crisis. Other market participants say it’s too early to call it quits.
“We expect a sharp loss in growth momentum in response to aggressive monetary tightening, but markets haven’t priced in for that,” Bank of America strategic analyst Sebastian Raedler said. He is seeing a drop of almost 20% for the Stock 600 index as figures start to show slower growth.
China’s bumpy recovery
With initial optimism about China’s reopening of Covid-19 padlocks now valued, the road ahead may be rocky. Consumer confidence remains near record lows in the world’s second-largest economy, the population is shrinking for the first time in six decades and the property market is still in recession.
European luxury goods makers,automakers and miners are among the sectors that will lose the most if the recovery is slower than expected, as they depend on China for a significant portion of sales.
