Morgan Stanley Sees 6% Upside for European Equities

MSCI Europe has 6% left to rise next year, according to Morgan Stanley’s equity strategists for Europe. That forecast is based on a 9% EPS growth, thanks to better GDP numbers and oil price forecasts, according to a report date Nov 26.

« While the macro backdrop is likely to remain good in 2018, we think risk assets will have a tougher time as growth momentum slows and valuations come under pressure from tighter monetary policy, wider credit spreads, higher volatility and a flat US yield curve », write Graham Secker, Matthew Garman, Krupa Patel, Lillian Huang and Alix G. Guerrini in the report.

Their sector recommendations include an overweight in Energy, Financial Services and Switzerland; while they underweight « China-exposure » and Cyclicals.

The key for market direction next year will be the rate of change in EPS growth, which could be affected by lower PMIs and EPS.

« Although our economists expect economic growth to remain strong in 2018, asset markets tend to be more sensitive to changes at the margin than to the absolute level. In this regard, the backdrop for equities looks a little less encouraging, as we have already started to see a deterioration in the year-on-year change in PMI indices (especially the global index) and the year-on-year comps are now more challenging, given the move up in economic indicators post the US election this time last year. This implies a similar slowing in the pace of equity returns, which could accelerate to the downside if the global PMI were actually to start falling year on year (as we saw in 2H15 and 2011). »

Morgan Stanley don’t expect much support from P/E expansion, which was a major driver of European market recovery (while in the US, earnings growth was the main driver over the last few years).

What are the positives ?

Better GDP outlook (2%+ in euro area), EUR strength abating, continued support to credit via the ECB, no flattening of the yield curve (which signals a risk of recession) are the major points here.

What are the risks ?

A sharp increase in volatility (widely expected by the US equity team), an acceleration in inflation, the inability of UK and European union to find terms on the Brexit, and a contraction in earnings growth (-1% vs base case of +9% in 2018) and a compression of P/E multiple to 13.5x (bear case) vs stability expected in base case around 15x.