Morgan Stanley
  • Thoughts on the Market Podcast
  • Sep 14, 2021

Re-engaging with Cyclical Value in Europe


Welcome to Thoughts on the Market. I'm Graham Secker, Morgan Stanley's Chief European and UK Equity Strategist. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about our latest thoughts on European equities and our preference for owning cyclical value companies into year end. It's Tuesday, September the 14th, at 2:00 p.m. in London.

September is always a busy and interesting time in markets as capital market activity rebounds post the summer lull and investors consider how best to position their portfolios into year end. While this month can sometimes produce a brief period of higher volatility, it tends to set the scene for solid returns in the final quarter, and we see a similar outcome for European equities this time, too.

Our optimism on European stocks, both in absolute terms and relative to global peers, is predicated on three pillars. First, the growth fundamentals in Europe continue to look favorable, with the region likely to be a GDP outperformer in 2022, given it is earlier in its recovery than the other regions and hence offers a greater rebound potential. We also see upside risk to consensus earnings forecasts for next year, as the current estimate of just 7% growth looks too low to us. If you go back to the start of every September over each of the last 30 years, you find that earnings forecast for the following year have never been this low before. For us, such low expectations are a positive, not a negative factor, as they provide greater potential for profit upgrades in the weeks and months ahead.

A second factor in favor of European stocks is their valuation, which is close to a record low versus either U.S. stocks or European bonds. The latter comparative is particularly relevant if you are a European asset allocator facing a choice between a real dividend yield on domestic stocks of +3% or a real yield on 10-year bunds of -2%. This 500bps real yield advantage for stocks is close to a record high.

Third, we think global investors remain significantly underweight Europe in their portfolios, while a period of general risk reduction from hedge funds in particular, over the summer, has left futures positioning in European indices at its lowest level in five years. The point here being that even modest inflows into the region could drive outsized price gains.

While we have remained generally upbeat on European stocks all year, we did take some risk off the table in May when we downgraded cyclicals, given a backdrop of high valuations, elevated positioning and ahead of a likely peaking out of economic lead indicators. Now, however, we think it's time to add risk back to portfolios again, as we believe that the summer growth scare is nearing a conclusion and that the absence of further negative news in this regard should be sufficient to prompt a tactical rally into year end.

Consequently, we have upgraded cyclicals back to overweight and are particularly focused on those names where valuations have fallen the furthest in recent months, such as Autos, Energy and Materials. We also like European banks, given consensus earnings expectations look far too low to us at just 1% growth next year. At the same time, the sector should be the biggest beneficiary of higher bond yields, it looks very cheap versus history and is about to see a big increase in dividend payouts as the European Central Bank eases restrictions.

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With the summer growth scare in Europe possibly nearing an end—and relatively inexpensive valuations—cyclical stocks in Energy, Banking and Autos may be worth a fresh look.

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