With macro newsflow tracking closer to our bear case than our base
case, we use scenario analysis around PE and EPS assumptions to
quantify potential further downside risks to European equities. On
today's N12M PE of 13.6, we estimate the market is pricing in a 2-
year EPS CAGR of c. 4%.
Recent macro newsflow has been more bear case than base case.
Although we argued that 2016 would be a tough year for European equities in
our year ahead report, we did not expect such a bad start to the year. Over the
last couple of months, the macro newsflow has broadly followed our bear case
scenario, especially around EM deterioration and FX tension. The lack of an
identifiable bull case is encouraging greater short activity in equities and
commodities.
12% downside before absolute valuations become appealing in their
own right
Absolute equity valuations are not yet low enough to warrant buying the
market on valuation alone, with MSCI Europe's N12M PE at its long-run
average. We calculate that the market would need to fall a further 12% to take
the average of 17 different absolute valuation metrics back to their long-run
median level.
Scenario analysis - we estimate market is pricing in 4% 2Y EPS CAGR at
N12M PE of 13.6.
The market is currently midway between our base case and bear case 12m
price targets, although equity valuations are now at our bear case PE
assumption of 13.6. At a N12M PE of 13.6 we estimate that the market is
currently pricing in a 2Y EPS CAGR of about 4%, while a move down to an EPS
CAGR of 0% would equate to a further 7% drop in equity prices. We estimate
33% downside under a full-blown recession scenario of a 20% drop in EPS and
a N12M PE of 12.
Key factors to watch - Earnings, China, EM, Fed.
The key factors likely to influence market performance in the coming weeks
and months are: i) Earnings season; ii) China & EM macro newsflow (especially
FX related); iii) USD and Fed commentary; iv) Industrial & commodity
performance; v) any signs of weakening in European macro newsflow.
Sector strategy - between a rock and a hard place
We have been too bullish on commodities and too bearish on defensives over
the last four months. With European quality stocks trading at a record high to
their US peers, coupled with a high degree of consensus positioning, we don’t
want to make a wholesale U-turn; however, we recognise the need to be
pragmatic. Consequently, we downgrade Energy to neutral and Div Fins to
underweight, while upgrading Telecoms to overweight and Healthcare to
neutral.