Could Bad News Mean Good News for European Equities? by Michele Patri, AllianceBernstein

Much of the recent economic data from the euro zone has been decidedly downbeat, with growth trends weak and signs of deflation emerging. The good news is that Europe’s policymakers are responding vigorously. We may now be in a “bad news is good news” scenario for European equities.

Draghi Steps Up a Gear

Faced with a euro-area economy in the doldrums, European Central Bank (ECB) president Mario Draghi is responding with a bold range of proposals that venture way beyond orthodox central bank policy. He’s suggesting a combination of fiscal and monetary stimulus initiatives, plus structural reform, that’s being dubbed “Draghinomics”, given its similarities with the ambitious “Abenomics” reform agenda of Japan’s prime minister, Shinzo Abe.

If successful, Draghinomics should have a positive effect on the real economy, while also lending support to European financial assets. The ECB has already pushed interest rates down as low as they can go and Draghi is proposing liquidity injections and asset purchase programs aimed at weakening the euro and encouraging the banking system to lend. All in all, we believe this represents a welcome shift from the view that deficit-reducing austerity measures would provide the lasting answer to all of Europe’s problems.

Banking on European Financials

In particular, we’re positive about the ECB’s plans to provide cheap long-term loans to Europe’s banks over almost two years. One of Europe’s more stubborn problems has been European banks (understandable) reluctance to lend given the pressure to conserve capital ahead of the ECB’s asset quality review (AQR) assessment of euro area bank balance sheets and stress tests. Once the AQR and the stress tests are out of the way in October, we think Europe’s banks are likely to prove increasingly willing to tap these loans. Over time, this should help the flow of credit to Europe’s businesses and, in turn, boost corporate demand for a range of business services as economic activity gradually starts to strengthen

Clearly, the shift to an environment in which Europe’s restructured banks are lending more should prove positive for the banking sector’s profitability prospects. As the sector’s deleveraging and recapitalization of recent years draw to a close, we see room for a profitability rebound when loan levels start to grow.

So, the policy backdrop for European stocks in general, and for European financials in particular, looks likely, in our view, to prove highly supportive. There are other reasons to be cautiously optimistic about the outlook for Europe’s equity markets. European equities are trading at discounts to their US and Japanese counterparts, suggesting they have scope to catch up once they start to report stronger earnings. And we expect this to happen as Europe’s more export-oriented businesses begin to reap the rewards of a weaker euro. Second, European equities should benefit from any rotation away from fixed-income assets as investor risk appetite starts to benefit from the ECB’s asset purchase program.

Taking a Balanced View

While the direction of ECB policy seems likely to support more cyclical stocks in particular, we continue to favor an approach that balances pro-cyclical names with more defensive holdings. This approach helps to balance the return potential of any uplift in investor risk appetite with protective positions intend to withstand potential shocks. Our analysis suggests that the combination of ECB policy and sector-wide restructuring is building a more supportive case for investing in financials stocks from a longer-term perspective—and European financials continue to trade at sizable discounts to their global peers.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams. AllianceBernstein Limited is authorized and regulated by the Financial Conduct Authority in the United Kingdom.

Michele Patri is Portfolio Manager, European Flexible Equities, at AllianceBernstein.