Trading insights: Risk and reward for European Equities post-YTD rally

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Eloise Goulder: Hi, I'm Eloise Goulder, head of the Data Assets and Alpha Group here at J.P. Morgan. And today I'm joined by my colleagues, Federico Manicardi and Victoria Campos, from our International Market Intelligence team to discuss European equities following quite a rally with the STOXX 600 up 6% from November lows and in fact hitting fresh all-time highs this week and marginally outperforming U.S. equities over the last two months. So, Fede, Victoria, thank you so much for joining us here today.

Federico Manicardi: Great to be here.

Victoria Campos: Thanks for having us.

Eloise Goulder: So, Fede, why do you think European equities have been so strong in recent months? I mean, on the face of it, the macro and the political narrative has continued to be one of U.S. exceptionalism. So, why do you think European equities have staged a bit of a comeback?

Federico Manicardi: So, yeah, with the main benchmarks finally breaking out of last year trading ranges, European equities are certainly in the spotlight. the rally started in mid-November, and it looks like there have been two phases in this. The first phase is from mid-November into year-end, and this was mostly a position-in-mid-reversion style move. European equities were oversold in absolute and relative terms, and the level of positioning were also quite low. The second phase of the price action is the year-to-date one, which looks to me more fundamental in nature. We have got some marginal positive in terms of political stability in France, we have seen ECB peak remaining consistently dovish, and the first part of the earning season has been positive in European luxury, as well as also for U.S. banks, which have clearly threw also in Europe. There is also a series of upside catalysts that investors have started to discount and have consistently come up in the conversation. The interesting bit is probably on the positioning side. On aggregate, investor surveys suggest long-goal is upcount and reverse that underweights and are still adding, while also CTAs and systematic accounts are buying. However, we have seen hedge fund investors adding to European ex-U.K. equities last year, but now they have started selling into this rally.

Eloise Goulder: That's fascinating. First of all, to hear about, in your mind, two phases of this European equity rally so far. The first one much more driven by the depressed positioning and technicals, but the second one driven more by tentative signs that fundamentals are improving. But hedge funds have not been buying into this second leg of the rally. So, Fede, as you look ahead, what's your view? Are you more bullish or bearish?

Federico Manicardi: Yeah, as we discussed in our previous podcast in mid-November, we've been constructing on Europe since late last year. Right now, however, we have neutralized our stance, but we do see some upside catalysts lined up. First of all, when we look at sell-side consensus expectation on European GDP growth, they look quite unassuming as effectively they project a flat line in growth extending to next year. This happens while we're getting healthy signs from the consumer in Europe from lower unemployment rate, rising disposable income, and significant excess savings. We are seeing a lending pickup as the ECB speak consistently remain dovish, and we are also seeing some improvement in the external environment, which is from China trying to revive its domestic demand via a mix of monetary and fiscal, and the U.S. growth keeps delivering. This is very important when you think that 60% of revenues exposure for Europe actually come from the external environment. A second catalyst could be a Russia-Ukraine peace or ceasefire deal. We think there would be a clear sentiment channel on the upside. However, we do think there is still uncertainty on energy flows resuming and also as to the final impact of reconstruction for European GDP. A third catalyst could be political stability as well as the prospect of a more business-minded government in Germany after election on February 23rd. And finally, when it comes to tariffs, we do recognize that uncertainty remains. However, it does seem like milder tariffs or more targeted tariffs is emerging, and there could seem to be room for negotiation via defense spending and/or energy imports for the European Union.

Eloise Goulder: So clearly several catalysts that could make you more bullish. But going back to my earlier point about U.S. exceptionalism, surely there is still a backdrop where Europe is facing structural headwinds. I mean, how do you think about the negatives here, Fede?

Federico Manicardi: Yeah, you're right.. I would start by mentioning the structural challenges to Europe, which remains. Energy prices remain high. Europe is relying a lot on manufacturing to create GDP growth, and this comes in an era where the U.S. is betting on reindustrialization. And finally, we see increasing competition from Asia on higher end sectors of the value chain. I would also mention that markets in our fair value framework effectively already discount an acceleration in business surveys, while the actual macro data that we have seen have only given limited and mixed signs of an inflection higher. I will also mention the earning season, which is coming next week. Our equity strategists do think that the earning season expectations for Europe can be a little bit punchy, especially considering that the pace of activity momentum last quarter was actually quite soft in Europe. And finally, markets are technically overbought with error size above 70s on pretty much all of the main European benchmark, and most of the positioning and mean reversion signals that have been firing in the last quarter have now neutralized.

Eloise Goulder: Thank you, Fede. Well, clearly a bit of a tug of war between some of the structural headwinds that remain here in Europe, but on the other hand, the incremental sources of upside across the macro political and geopolitical landscape. So, I understand you're holding this neutral stance on Europe as an index, but under the surface, are there pockets where you do have a bullish view right now?

Federico Manicardi: Yes, of course. So, the year has started with momentum strategy continuing to do well, which reflect the fact that some of the themes of last year, like banks, industrials, defence and software have remained quite strong. We don't want to fade these themes, but we do see more upside coming from sectors that have been challenged last year and are giving sign of an upside rotation. among luxury, we continue to see some upside following a slowdown in the second part of 2024. Our research team has also recently put out a comprehensive set of indicators in this space, which still points at fundamental headwinds, but it could also be pointing at some inflection higher. We also see some positive fundamentals here in the form of less uncertainty coming from elections, which are now behind, which is a positive for discretionary spending, as also rising consumer spending, which is effectively a determiner of luxury earnings. We also like broader European real estate, as valuations in the sector are quite low, and we also see a dislocation relative to where bond yields are trading, particularly in a situation where the ECB is giving a consistently dovish message, and we could see the BOE turning more dovish. Finally, in the European semi-space, the news flows continue to be positive in the AI supply chain, the entry point is attractive relative to the comparables in the U.S. and Asia, and also here, positioning is still quite low while our analysts think that the worst data point in the semi-equipment space are actually possibly behind. 

Eloise Goulder: Thank you Fede, So Victoria, can we turn to you now? I mean, how much does the narrative that Fede has given across Europe also apply to the U.K.?

Victoria Campos: Yeah, so the U.K. has infamously been caught between the U.S. and Europe when it comes to macro weaknesses, firmer pricing and weaker activity. And the combination of this with challenges in the fiscal landscape have proved a tough pill to swallow for markets, with guilt sparing the brunt. 30-year yields reached levels last seen in the 90s, nearing 5.5% in early January this year. But last week's dovish CPI print did a lot to pair the sell-off, with record demand for Tuesday's guilt auction helping ease some of these fiscal concerns. I think it's also worth noting that guilt moves are often overemphasized in the context of fiscal impact, with our economists estimating that moves in rates by around 50 bps would push up deficit on average by 6 billion pounds, whereas a growth undershoot would be more pronounced, shaving off 17 billion pounds from fiscal headroom if near-term OBR forecasts are revised down half a percentage point. This number is a lot more material considering the treasury only has 9.9 billion of headroom. But the government has been quite quick to address this, with their pro-growth agenda picking up of late. Recent announcements have included boosting ties with China, a push on deregulation, an AI strategy statement, and new infrastructure projects.

Eloise Goulder: And when we think about U.K. equities, I mean, the FTSE 100 has also hit a fresh all-time high and is up around 5% year-to-date. So what's your view there?

Victoria Campos: Yeah, so we have some key catalysts coming up for U.K. equity markets in the coming weeks. PMIs this Friday should shed light on broader sentiment and growth outlook, and the Q4 GDP print, which is due in mid-Feb, will be a crucial data point and should help align expectations for the OBR's next forecast update at the end of March. Markets will also be closely watching the Bank of England's February meeting after the downside CPI surprise and increasingly dovish Bank of England comms. The most recent one being from Alan Taylor, who made the case for multiple cuts this year. markets are yet to price a more dovish path for the BOE, with only two whole cuts priced for 2025 currently. So a dovish surprise could catalyse further downside in yields and a subsequent boost to equities. Whilst improving domestic data and lower rates should benefit the FTSE 250, we remain more constructive on the FTSE 100 going forward, largely because of its exporter skew, which benefits from a weak sterling. We think additional downside on the currency is possible, given BOE carry can erode more quickly relative to market pricing if data continues to trend the right way. We like banks on strong earnings expectations, deregulation initiatives and a potential interference in the motor finance case. And we also see upside for homebuilders if yields continue to trend lower, with our basket down over 30% versus 2024 highs. Recent headlines on easing mortgage lending rules should also provide a boost to the sector. But I think it's worth emphasising that the U.K. still faces downside risks, given an uncertain domestic political environment as well as markets trading at a high beta to U.S. and global markets. So until we see more significant GDP prints it's hard to see how this narrative moves beyond a tactical take.

Eloise Goulder: Well, thank you so much, Federico and Victoria. It's been a really fascinating time to discuss Europe and U.K. equities in the context of these fresh all time highs that the indices have been making. And very helpful to understand that at the margin, you're holding a neutral view on the index levels, following your more bullish call back in November when we last recorded a podcast together. But that there are several sectors where you do have a more bullish view, whether Federico, it's across European luxury or real estate, or Victoria, it's across U.K. home builders or banks. Thank you both so much for taking the time to speak with us today.

Federico Manicardi: Thank you, Eloise.

Victoria Campos: Great to be here.

Eloise Goulder: Thank you also to our listeners for tuning into this biweekly podcast series from our group. If you have feedback, or if you'd like to get in touch, then please do go to our website at jpmorgan.com/market-data-intelligence, where you can reach out via the contact us form. And with that, we'll close. Thank you.

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