We remain cautious on European equities given a weak macro and earnings backdrop, high absolute valuations and elevated risks. We upgrade large-caps and Pharmaceuticals to overweight and downgrade commodities. Financials are oversold and should benefit from ECB action.
We now forecast EPS to fall by a further 5% in 2016
We cut our 2016 EPS growth forecast from 1% to -5% reflecting weaker economic forecasts, a more downbeat outlook for Financials' profits and an increasing drag from commodity sectors. Even excluding the latter we see no EPS growth across Europe this year .
Absolute valuations look high – 2% downside to our new 12m index target for MSCI Europe
We believe absolute valuations are too high given the backdrop of weaker economic and profit growth and an elevated risk profile. Europe's median stock trades on a N12M PE of 15.8 and absolute valuations in general are
around 15% above the long-run average. Our new rolling 12m price target for MSCI Europe is 2% below current spot prices.
Upgrading Pharmaceuticals to overweight
Post the recent rotation some of the more defensive/quality areas of the market are no longer so overbought – e.g. just 30% of defensive stocks outperformed the market over the last 1M. We upgrade Pharmaceuticals to overweight – it is 2SD oversold, is the only defensive sector to trade below its long-run relative valuation average and should benefit from any rebound in USD.
Downgrading Commodities
We believe the recent rally in commodity stocks is vulnerable to renewed USD strength that our FX strategists expect. With the oil price looking overbought we downgrade Energy to underweight. We downgrade Materials to neutral, rotating from Miners to Steel.
Banks/Financials look oversold and should benefit from ECB action
Banks is the one unloved value sector that has continued to disappoint this year. With just 6% of Bank stocks having outperformed over the last month (a record low) the sector looks very oversold while relative valuations have only
been lower in 2000 and 2008. Recent ECB policy actions should help the sector and we reiterate our overweight on Banks. We upgrade Insurance to neutral.
Upgrading large-caps to overweight
We upgrade large-caps to overweight as we believe they offer one of the best risk-reward profiles for investors wishing to lower their beta. Mid and small cap stocks look increasingly vulnerable at this point having continued
outperforming recently despite weaker economic and credit trends.