Deutsche Bank: "We See No Further Upside For European Equities..."

It seems like more and more of the big names are turning bearish on risk. Day after day of directionless trading, huge intraday swings in the equity markets, and a very confusing macro backdrop has bred a lot of frustration amongst investors and traders, ourselves included.

As such, many analysts seem to be throwing in the towel on betting on another move in the markets. Many have posited that the current scenario should extend until the Fed makes its next move, or some other major central bank steps up to the occasion (ECB or BoJ).

And we have to agree, that it has been exceedingly frustrating to try squeeze out excess returns in this relentlessly choppy market, where longer term views are often cut off before they have time to develop themselves, just because volatility doesn't permit.

Having no position is a position

We ardently advocate staying on the sidelines because we just don't know what is going to ensue. Yes, we have our own biases (with whatever we discussed about here, here, and here) but these biases aren't going to be beneficial in anyway unless the markets start trending again, which at this point is highly unlikely.

The number one principal for both small and big players would then be to preserve capital and ride out the volatility. We prefer to stay very lowly exposed or not exposed at all.

Another thing that we wish to point out is that because so many banks and analysts have turned the coin to being bearish on equities and risk markets in general, there might be a contrarian reason to be a little more cautious if you are in the bear camp. This is for the simple reason that most analysts and commentators are usually wrong about directional calls, and this might just be one of those cases.

DB sees little upside in European stocks

Regardless, here is Deutsche Bank's take on the European equity markets in specific, the reasons why it doesn't see anymore upside in stocks, and a few points about the Fed.

Although we do not agree with every point in such pieces of external analysis which we occasionally publish, there are valid points that can be taken away. Readers are encouraged to digest them, but also have their own personal views.

From Deutsche Bank's European Equity Strategist Sebastian Raelder, titled "No further upside for 2016":

In January, we projected that the Fed rate hike would lead to increased financial stress and falling equity markets; this, we argued, would lead the Fed to turn more dovish, which – in turn – would allow equities to rebound. This has played out. Yet, the Fed relent has been partial – and the latest FOMC minutes point to increasing risks that we will re-enter the “doom loop” from a more hawkish Fed to a stronger dollar, lower oil prices, higher HY credit spreads and lower equity markets.
On the upside, we think the Fed’s increased sensitivity to the problem of dollar strength means it will quickly abandon its tightening intentions once asset prices are falling, thus capping the downside for markets. Overall, though, the combination of weak global growth, Fed risk, a likely fade in China’s growth rebound and fragilities in the US high-yield credit market significantly undermines the upside case for European equities from current levels. As a consequence, we reduce our end-2016 Stoxx 600 target from 380 to 325, 4% below current levels. We introduce our end-2017 target of 345. We project 2016 EPS growth of minus 2% (down from our previous projection of 4.5% and compared to consensus at 0.5%), implying EPS of €21.3.
We project our index target using a probability-weighted scenario analysis:
  1. Muddle-through scenario (50% probability): Either no Fed rate hike – or a quick dovish turn by the Fed after one additional hike to limit the market fall-out. Chinese and global growth only slow moderately, commodity prices hold up and credit spreads remain well-behaved. In this scenario our models project a fair-value level of ~350 for the Stoxx 600.
  2. Downside scenario (35% probability): We re-enter the “doom loop”, against the backdrop of a sharper-than-expected slowdown in China. Commodity prices drop and credit spreads widen. Our models project ~270 for the Stoxx 600.
  3. Upside scenario (15% probability): The Fed does not hike despite accelerating global growth, driven by more easing in China and the delayed positive impact from lower oil on DM consumption. Stronger growth, easier financial conditions and declining macro uncertainty (due to a pro-EU vote in the UK referendum) boost asset prices. The fair-value level for the Stoxx 600 rises to ~375.
Four main negative catalysts for European equities over the coming months:
  • Global macro momentum is likely to remain weak: US growth is set to remain mediocre (given weak productivity growth and an inventory overhang), while China’s growth rebound is set to fade (as the impact of Q1’s aggressive credit stimulus dissipates). EM is encumbered by high private-sector debt, the risk from a hawkish Fed (leading to more capital outflows) and weaker commodity prices (due to a stronger dollar and weaker Chinese growth), while the prospect for European growth remains unexciting.
Chart courtesy of Deutsche Bank

Chart courtesy of Deutsche Bank

  • The Fed will likely try to hike at least once this year unless asset prices fall or macro momentum slows sharply (none of which would be good for European equities). Any Fed hiking attempt is set to put renewed downside pressure on the RMB (as short-term yield differentials move against the Chinese currency) – as well as adding to dollar strength, which is set to push down oil prices and push up US HY credit spreads, hurting risk sentiment more broadly.
Chart courtesy of Deutsche Bank

Chart courtesy of Deutsche Bank

  • We see upside risks for US high-yield spreads: these are priced for default rates to decline to ~3.5% by year-end, even as realized default rates keep rising (they hit 4.4% in April), lead indicators point to further upside for defaults and our strategists sees a two-in-three chance of a turn in the credit cycle of the coming months. Every 100bps rise in HY credit spreads is associated with a 4.5% drop in the fair-value level of European equities, according to our model
Chart courtesy of Deutsche Bank

Chart courtesy of Deutsche Bank

  • Valuations and sentiment are not particularly supportive: our P/E model points to 2% downside, while our ERP model suggests fair value is 7% below current levels. Investor sentiment is at neutral levels, according to our indicators.
Chart courtesy of Deutsche Bank

Chart courtesy of Deutsche Bank