Here’s What Can Go Wrong for Europe’s Powerful Equity Rally

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European equities are the flavor of the month. But it won’t take much for investor sentiment to sour again.

With a 10% surge in January, euro-area stocks are beating the US to enjoy their best ever start to a year. But top investors including BlackRock Inc. and Amundi SA warn that markets are being too sanguine about risks ahead.

A lot can derail this rally. Earnings downgrades are gathering pace, while the European Central Bank is holding on to its hawkish stance in the face of recession as inflation – though easing – remains elevated. And there’s no resolution in sight to the war in Ukraine that began nearly a year ago.

“It’s dangerous to think just because stocks are going up that things are okay,” said Kasper Elmgreen, head of equities at Amundi. “We’ve now got a very high conviction that 2022’s resilience will break. The market has not yet appreciated the magnitude of earnings downgrades ahead.”

Lower energy prices, signs of cooling inflation and China’s accelerating reopening have boosted sentiment, with the Euro Stoxx 50 Index up 27% since a low in September. Cash is also starting to flow back into European equity funds after nearly a year of redemptions.

But top asset managers have remained cautious, and trading data suggest the gains so far were driven by shortsellers covering positions. BlackRock Investment Institute strategists have said stock-market optimism has come too soon, while those at Goldman Sachs Group Inc. and Bank of America Corp. warn that the best part of the 2023 rally could be over already.

Read More: Goldman, BofA Say European Stocks Rally in 2023 Is Mostly Done

Here are the top five risks that could send European stocks tumbling:

War in Ukraine

Russia’s control of gas supplies to Europe continues to threaten economic growth. While a milder winter helped the region avert an energy crisis this time around, more policy intervention may be needed if Russia halts supply.

Almost a year since an invasion that was supposed to take weeks, Vladimir Putin is preparing a new offensive in Ukraine, while the US and Germany are sending tanks to Ukraine in a broad allied effort to arm the country with more powerful weapons. The moves signal potential for the war to escalate.

The energy war “could continue for a long duration,” said Aneeka Gupta, a director at Wisdomtree UK Ltd. “As we can’t always rely on favorable weather, measures such as shoring up gas reserves and rationing of energy demand will need to continue.”

Earnings Pain

Analysts have been slashing earnings forecasts going into the reporting season, with some strategists calling for even deeper cuts against the backdrop of slowing growth. With inflation easing, companies are also finding it more difficult to raise prices at a time when demand is slowing.

In credit, the combination of persistent inflation and higher rates is going to strain the liquidity position of many companies, as margins shrink and it becomes more expensive to service their debt.

Early indication from the reporting season shows there’s cause for worry across industries. Retailer Hennes & Mauritz AB said surging costs nearly wiped out profit in the last quarter, wind-turbine maker Vestas Wind Systems A/S warned of another hit to sales this year, while software maker SAP SE is planning jobs cuts in a bid to boost profit.

Bottom-up analysts are predicting flat earnings growth in Europe this year. Top-down market strategists have a bleaker view, with those at Goldman Sachs, UBS Group AG and Bank of America expecting profits to fall between 5% and 10%, signaling further share losses as valuations catch up to the lower projections.

Wrongfooted on Policy

The latest messaging from ECB policymakers suggests they will stay the course on interest-rate hikes until they see a more meaningful pullback in inflationary pressures. Yet stock investors are optimistic about a soft-landing for the economy and rate cuts later this year.

That dissonance has seen equities move in sync with bonds – where investors are focusing on a recession – and could lead to shares tumbling if the ECB does stay the hawkish course for longer.

“This is one of the areas where the market’s way too optimistic,” said Joachim Klement, head of strategy, accounting and sustainability at Liberum Capital. Elevated inflation through 2023 means policymakers will have “little to no room to cut rates even in a recession. If central banks don’t want to repeat the mistakes of the 1970s, they need to wait until inflation is close to 3%, something we do not expect before 2024.”

Recession Woes

The jury’s out on the R word. Some economists including at Goldman Sachs say the euro zone could avoid a recession altogether this year, citing signs of resilient economic growth and the averting of the energy crisis. Other market participants say it’s too early to call it.

“We expect a sharp loss of growth momentum in response to aggressive monetary tightening, but markets are not priced for this,” said Bank of America strategist Sebastian Raedler. He sees a downside of almost 20% for the Stoxx 600 Index as data start to show slower growth.

Uneven China Recovery

With early optimism about China’s reopening from Covid-related lockdowns now priced in, the path ahead may be rocky. Consumer confidence remains near record lows in the world’s second-biggest economy, the population is shrinking for the first time in six decades and the property market is still in the doldrums.

European luxury-goods makers, auto companies and miners are among industries that stand to lose the most if the recovery is slower than expected, as they depend on China for a significant portion of sales.

–With assistance from Jan-Patrick Barnert and Irene García Pérez.

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Source: https://finance.yahoo.com/news/wrong-europe-powerful-equity-rally-080000201.html