Europe's fragile US$2t stock rally fails to win over big investors

[LONDON] European equities are turning in their best year of gains in a decade and a growing chorus of brokerage strategists is betting the market can outdo its more popular US peer in 2020. Many big investors aren't buying it.

There are plenty of reasons to be optimistic: Many investors missed out on a surprisingly strong rally that added about US$2 trillion to European stocks this year, leaving ample room for new buyers. And the market sells at a near-record discount to the US at a time when when JPMorgan Chase & Co is touting it in a bet on an economic recovery.

But just as the club of European stock fans kept expanding, Monday delivered a reminder of the region's vulnerability, as both the Stoxx Europe 600 Index and Germany's DAX Index underperformed the Standard & Poor's 500 Index on weak US manufacturing data and German political uncertainty. And in a triple whammy, President Donald Trump on Tuesday signaled he's willing to wait another year to strike a trade agreement with China.

The European market's success in 2020 hinges on numerous moving parts, including the UK's ability to complete Brexit, the state of the German economy, the strength of corporate earnings and manufacturing as well as the outcome of US elections and trade talks with China. This is making the likes of Aberdeen Standard Investments prefer the US.

"Although valuations are preferable for European equities, we are less convinced that European firms will be able to deliver as strong a recovery in company profits after the slowdown in 2019," said Andrew Milligan, head of global strategy at Aberdeen Standard. "While US presidential politics will undoubtedly be a factor in encouraging or discouraging capital flows into the US during 2020, the euro zone also faces its own political headwinds."

The Stoxx 600 on Tuesday fell for the fourth day, erasing a gain of as much as 0.5 per cent. The U.K.'s FTSE 100 Index underperformed other benchmarks with a slump of 1.6 per cent, led by oil majors BP and Royal Dutch Shell  as crude prices dropped.

While the US is preparing for an exciting election cycle in 2020, which many strategists expect will boost volatility and lead to weaker stock market returns, nothing compares with the headache of navigating European politics.

German Chancellor Angela Merkel's ruling coalition suffered a blow with the election of government skeptics as co-leaders of Germany's Social Democrats at the weekend. A collapse of the coalition would end Mrs Merkel's political career, though the Social Democrats at a conference later this week may choose to negotiate a way forward with Merkel's CDU-led bloc.

The Brexit drama is also far from over. Even if the Tories manage to win a majority during the Dec 12 election, the negotiation over the terms of the UK's exit from the European Union is likely to take some time.

Even though the days of double-digit earnings growth in the US are in the past, it's still outpacing Europe. Next year, analysts see profits for companies in the Stoxx 600 climbing 8.9 per cent compared to 9.2 per cent for those in the S&P 500, according to data compiled by Bloomberg.

Analyst earnings downgrades for Europe excluding the UK have been outpacing upgrades since April until they turned flat at the end of November. This has allowed many companies to beat expectations during the latest reporting season, though the consumer-goods, banking and oil sectors delivered somber warnings.

Over at UBS Global Wealth Management, the tepid profit growth outlook is the reason the asset manager prefers US equities to Europe.

"The US profit cycle feels long in the tooth but we still see that a mix of better revenue growth and higher and more sustainable margins than in the euro zone and greater volumes of share buybacks are likely going to mean that U.S. earnings growth is going to outperform euro-zone earnings growth," said Maximilian Kunkel, chief investment officer for Germany at UBS Global Wealth Management.

Tuesday brought a fresh stream of macro data that underscored vulnerabilities on both sides of the Atlantic. Equities slumped after a measure of US manufacturing late Monday contracted against a backdrop of weaker orders and subdued production, showing how sensitive Europe remains to the situation in the US.

In Germany, factory manufacturing data beat expectations but was far from suggesting a strong rebound in growth. The economy still faces obstacles, particularly in the auto industry, and employment in manufacturing continues to fall.

Despite all these concerns, some investors say European stocks offer an attractive discount to the US, especially relative to the negative returns on cash and fixed income.

"We see the outlook next year as one of slow but steady growth, muted inflation and mildly supportive monetary policy," said Joseph Little, global chief investment strategist at HSBC Global Asset Management.

BLOOMBERG