SocGen Bearish On European Equities Going Into 2019…

The bank expects the Stoxx Europe 600 to be about flat over 2018, before contracting by 19.5% in 2019, in part due to the anticipation of a US slowdown by 2020. By 2 years time, the European market should endure a krach.

Source: SG Cross Asset Research

Per SocGen’s report dated Nov 23:

« We do not see much upside on our major equity targets for the next 12 months. We expect stretched valuations and rising bond yields to limit equity index performances in 2018 and the prospect of a US economic slowdown in 2020 to further cramp returns in 2019. We also raise some concerns about the quantity of shorts on volatility, which could potentially strongly deteriorate the risk reward profile of equity markets. »

The outlook for European equities is mediocre: SG expects Stoxx Europe 600 to finish 2018 at 385 points, then to fall to 310 points in 2019 (-19.5%) before getting back to 340 points by the end of 2020.

DAX 30 and CAC 40 would follow a similar pattern, but the first would fall by 18.5% in 2019 while the CAC would contract by 18.2% to end 2019 at 4,500 points.

Despite a firming recovery in Europe, the key reasons behind poor expected returns are a stretched valuation (P/E in line with historical average) and a stronger euro that would represent a major headwind for earnings growth.

US Equities: some key facts

US Equities are trading above their long-term average, yet expected earnings growth for the next 12 months (12%) is below the 20y annual earnings growth average (14%).
Volatility is historically low which reflects both the accommodative monetary policy backdrop but also massive short positioning on VIX, meaning any spike in VIX could be amplified by short covering.

As SocGen’s strategists write:

« The risk/reward has been very attractive for US equities: good expected return supported by reasonable valuation and EPS growth, a very low Fed fund rate and an ultra-low volatility regime. At current 12-month forward P/E, we factor in our Fed Fund scenario and a different volatility regime. A change of VIX regime from 10% to 15% would push the US equity Sharpe ratio back to its historical average. »

If US long term yield get closer to 3% (2.7% expected by Soc Gen end-2018), this should represent a significant headwind for US equities. Remember that US dividend yield (2%) is lower than US Treasury yield (2.3% for 10Y).

Contraty to the past, 50% of last 12 month S&P 500 performance is related to P/E expansion, vs 26% since 2009 market trough and 36% over the last 5 years. Most of this recent multiple expansion has been related to the tax reform, yet, as SocGen’s strategists observe, the top contributors to S&P 500 performance already have tax rate below the current rate of 35% (Amazon being the only exception), while most of them trade at multiples above market average.