Risks for euro area equities have risen relative to the U.S. in the aftermath of Brexit. At least in the near term, the U.S. market is comparatively more attractive, with the Brexit vote casting a shadow over the economic outlook for the euro area. The growth outlook is the driver of expected relative performance for the two markets.
On a 0-3 month horizon MRB is underweight the euro area versus the global benchmark, while overweight the U.S. An upgrade of euro area equities is contingent on evidence that the fallout from Brexit will be limited and the ongoing euro area economic recovery will be sustained.
The U.S. market will outperform if global growth is mushy or deteriorates. Underlying economic fundamentals are better in the U.S., given the more advanced stage of deleveraging of the U.S. household sector, the contribution to growth of the government sector, and the comparative health of the financial sector. Moreover, U.S. corporate profits should hold up if the U.S. economy is reasonably firm, while euro area profits are vulnerable if domestic and/or global economic conditions deteriorate.
The euro area financial sector is more exposed if regional growth conditions weaken. Euro area financials have dramatically underperformed their U.S. counterparts in the past year, as concerns about asset quality have mounted. Italian banks, in particular, are under severe duress and risk creating financial contagion for the broader regional sector in the absence of prompt policy support (most likely in the form of a government sponsored re-capitalization program). Concerns over euro area financials will intensify if regional growth weakens. In contrast, the U.S. financial sector is comparatively robust, with a healthy capital base and solid loan quality, as highlighted in the recent Federal Reserve stress tests.
The outperformance case for euro area equities is contingent on a number of factors that are now less likely following the Brexit vote. Euro area equity outperformance requires continuing economic improvement in the regional economy, still solid growth in the U.S. and stability in China, as well as at least moderately rising U.S. equity prices.
Looking ahead, we would need to anticipate improving regional and global growth in order to upgrade euro area equities to overweight versus the U.S. Euro area authorities will need to ring-fence the region’s banking system, and buttress consumer and business confidence, in order to sustain the economic recovery. We will be keeping a close eye on euro area confidence measures and policy guidance, but it will likely take 1-2 months before any clarity on the fallout from Brexit becomes apparent. At least until then, the risks favor the U.S.
Peter Perkins, The Macro Research Board
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