Is Europe’s Outperformance Sustainable?

31 May 2023

By Danish Lim, Investment Analyst, Phillip Nova

 

The Euro STOXX 50 Futures contract, which represents the 50 largest and most liquid stocks in the Eurozone, fell last week by -1.25%, but is overall still up +12.76% YTD as of 31 May 2023, around 3pm Singapore Time. European equities have rebounded and outperformed the US this year, aided by falling natural gas prices, China’s reopening, and prospects of the US rate hike cycle coming to an end. Luxury stocks such as LVMH and Hermes are some of the top performers YTD.

 

We maintain a bearish outlook on the Euro STOXX 50 Futures contract as we believe that the YTD outperformance of European equities is unsustainable, given the increasingly gloomy macroeconomic backdrop. Germany, the Eurozone’s largest economy and an industrial powerhouse, is in the midst of a technical recession, having suffered 2 straight quarterly declines in GDP.

 

Fundamentally, we think that some of the positive catalysts present at the start of the year are fading. European luxury stocks, major drivers of the STOXX 50 in H1 2023, are starting to lose their appeal as China’s post-COVID economic recovery is starting to lose steam. Chinese markets have already given back all of their YTD gains and are in negative territory; as Chinese manufacturing activity moved further into contraction territory in May. Absent meaningful fiscal stimulus from the PBoC, we believe China’s reopening will no longer serve as a major positive catalyst for European equities.  

 

Eurozone manufacturing PMI has been in contraction territory since June last year, with the latest May print coming in at a 3-year low of 44.6, down from 45.8 in April.

 

Additionally, Eurozone inflation is currently stickier than expected, with Headline Eurozone CPI coming in at 7.0% in April, up from 6.9% in March. This comes after the ECB raised its deposit rate to 3.25% in the most aggressive tightening cycle in the ECB’s history. ECB President Christine Lagarde said that the “fight is not over” as “inflation has been too high and for too long”. ECB officials have also signalled that they are willing to continue hiking even if the US Fed pauses, with most officials expecting at least 2 more rate hikes in June and July. Dutch central bank chief Klaas Knot also said that rates will held at peak level for a “significant” period of time.

 

On a fundamental perspective, we expect inflation persistence to translate into a higher for longer interest rate regime in the Eurozone. The YTD rally this year signals to us that investors are paying little mind to broad manufacturing weakness and focusing on strength in the services sector instead.

 

Thus, we think that European markets have yet to fully price in an increasingly gloomy economic picture, as well as a hawkish ECB. This likely reflects market expectations for a “goldilocks” scenario where inflation and interest rates both decline without a recession. In our view, this seems overly optimistic. In conjunction with China’s reopening no longer being a key growth driver, we believe the YTD outperformance of European equities may eventually prove to be unsustainable and maintain a bearish outlook on the STOXX 50 Futures contract.

 

On a technical perspective, an uptrend in the STOXX 50 Futures contract since September last year looked to have ended with a downside breakout observed on 24 May, but the contract saw a temporary retracement back towards its dynamic trend line resistance around 4350. We attribute this retracement to renewed risk appetite following positive progress on US Debt Ceiling negotiations.

 

As of 31 May at 3.30pm local time, the contract has moved further downwards to close below the trend line and finds itself trading below the 50-day Moving Average around 4275. We anticipate continued downward pressure on the contract as markets refocus on the poor economic backdrop. We maintain a bearish outlook because:

  • The Moving Average Convergence Divergence indicator (MACD) validates our bearish outlook by showing a bearish crossover signal- represented by the MACD line being below the signal line. The MACD histogram also looks to be further deeper in negative territory, signalling bearish momentum.
  • The contract is also trading below the 50-day Moving Average, pointing to bearish momentum.

 

In closing, we hold a bearish outlook on the STOXX 50 Futures contract. We believe that positive catalysts such as China’s reopening boost are fading. The likelihood of the ECB keeping rates higher for longer due to sticky inflation should also cap equity upside and limit gains. We forecast the contract to head downwards to test dynamic support at the 100-day Moving Average around 4238-4240. If breached, expect our thesis to further materialize with further declines towards the 76.4% retracement level around 4130-4132. A break below could see the contract head further downwards to the 61.8% retracement around 3960-3955. The worst-case scenario of a Eurozone recession could see the contract test the 50% retracement level around 3820-3822.

 

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1) Has the ARKK been sunk?

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