European equities’ outperformance seen as unsustainable
THE Euro STOXX 50 Futures contract represents the 50 largest and most liquid stocks in the eurozone. It fell last week by 1.25 per cent, but is overall still up by 12.76 per cent year to date (YTD) as at May 31, 2023. 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, suffering two consecutive 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, the 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 manufacturing activity moved further into contraction territory in May 2023. Without meaningful fiscal stimulus from the People’s Bank of China, we believe China’s reopening will no longer serve as a major positive catalyst for European equities.
The eurozone manufacturing PMI has been in contraction territory since June last year, with the latest May print coming in at a three-year low of 44.6, down from 45.8 in April 2023.
Additionally, eurozone inflation is currently stickier than expected, with headline CPI coming in at 7.0 per cent in April, up from 6.9 per cent in March 2023. This comes after the European Central Bank (ECB) raised its deposit rate to 3.25 per cent in the most aggressive tightening cycle in its 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 their willingness to continue hiking even if the US Federal Reserve pauses, with most officials expecting at least two more rate hikes in June and July this year. Dutch central bank chief Klaas Knot also shared that rates will hold 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 implies that investors are placing little emphasis on broad manufacturing weakness and focusing on strength in the services sector instead. Therefore, we think that European markets have yet to fully price in the ECB’s hawkish stance nor the increasingly gloomy economic picture.
BT in your inbox
Start and end each day with the latest news stories and analyses delivered straight to your inbox.
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 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 appeared to have ended with a downside breakout observed on May 24. The contract, however, saw a temporary retracement back towards its dynamic trend line resistance around 4,350. We attribute this retracement to renewed risk appetite following positive progress on the US debt-ceiling negotiations.
As at May 31, the contract has moved further downwards to close below the trend line and finds itself trading below the 50-day moving average around 4,275. We anticipate continued downward pressure on the contract as markets refocus on the poor economic backdrop. We maintain a bearish outlook as:
a. With the moving average convergence divergence (MACD) line below the signal line, this signals a bearish crossover, validating our bearish outlook. Furthermore, the MACD histogram also looks to be further deeper in negative territory, signalling bearish momentum.
b. The contract is also trading below the 50-day moving average, pointing to bearish momentum.
In conclusion, 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 4,238-4,240. If breached, expect further declines towards the 76.4 per cent retracement level around 4,130-4,132. A break below could see the contract head further downwards to the 61.8 per cent retracement level around 3,960-3,955. The worst-case scenario of a eurozone recession could see the contract test the 50 per cent retracement level around 3,820-3,822.
The writer is investment analyst at Phillip Nova
Copyright SPH Media. All rights reserved.
