Why European Equities Will Likely Produce Strong Returns

Why European Equities Will Likely Produce Strong Returns
Source: Societe Generale Research

Paul Jackson, from Societe Generale, continues to expect attractive returns over the next three to five years for European equities, underpinned by better economic performance. Mr. Jackson’s equity strategy team re-emphasizes their shift from growth to value sectors, by downgrading pharmaceuticals and aerospace and defense (from neutral to underweight), and upgrading telecoms and utilities (from underweight to neutral). From the chart below, pharmaceuticals, aerospace and defense have performed well over the last 12 months and further upside may be limited. Even though telecoms and utilities have underperformed, these sectors rank among the cheapest in the market as they can generate returns in excess of bond yields even if their dividends decline. Societe Generale analysts believe that while policy tightening may hamper upside, such event is not likely in the foreseeable future.

Cyclical sectors will continue to outperform

Against this backdrop, Societe Generale’s equity strategy team thinks that cyclical sectors will continue to outperform. Recent strength in retail has been surprising in light of rising bond rates, while the underperformance of construction has been frustrating relative to expectations of higher returns (Societe Generale remains overweight in this sector).  The upper left-hand corner of the chart below shows the sectors that Societe Generale favors based on discounts relative to the market over the last 12 months. The table below summarizes Societe Generale sector ratings and recommended stocks.

European Equities Value and Momentum
Source: Societe Generale Research
European equities Recommendation european sector allocation
Source: Societe Generale Research

Effect of tapering on European equities may be limited

Societe Generale economists and rate strategists think Federal Reserve bond purchases will end in March 2014, reserve draining and completion of MBS reinvestments will likely start in late 2014 (end of monetary easing), and rate hikes may start in mid-2015. Provided economic improvement continues in the U.S., Societe Generale forecasts a 6.5 percent Fed Funds rate by the end of 2017.

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It is unlikely that stock prices will decline substantially in the first stage of the rate rising cycle, as policy tightening will be initially associated with better economic performance and potential growth prospects. Both of these factors support upside in stock prices. However, the correlation between equities and bond yields could switch to negative once bond yields reach a certain level (historically 5 percent). Given that 10-year U.S. Treasury yields are around 2.62 percent, there is still some room for increasing yields before equities experience losses. The turning point for bond yields could take place in late 2014 or early 2015.

European equities Index targets

European inflation likely to remain subdued supporting stocks

According to Societe Generale economists, inflation pressures will likely remain subdued in the Euro Area. The European Central Bank (ECB) reported that money supply (M3) in the Euro Area expanded by 2.3 percent year over year during the month of August, a slight increase over the 2.2 percent year over year expansion reported in July. Both increases remain well below the 4.5 percent growth target mandate set by the ECB. Meanwhile, private sector loans declined by 1.5 percent year over year in August suggesting that a recovery in business investment is unlikely during the third quarter of 2013. In contrast, consumer loans increased by 0.4 percent year over year in August. Societe Generale economists conclude that the tepid growth in monetary supply and credit together with a possible euro appreciation will probably keep inflation low in the foreseeable future. In turn, increases in European bond yields will likely remain limited supporting stock prices.

European equities Money and credit ECB target

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