Upgrading European equities; downgrading EM debt

We are upgrading our view of European equities to overweight from neutral. We see European stocks as big beneficiaries of the broadening global reflationary environment and believe investors are too skeptical of the region’s prospects.

Analysts repeatedly slashed their European earnings growth forecasts in recent years as early optimism faded. Yet 2017 appears different, with upgrades following a late 2016 upward trend. Projected earnings growth is now mostly coming from cyclical sectors that benefit from improving global growth and a weaker euro.

A brighter outlook

The economic outlook is picking up. Our BlackRock GPS gauges show the U.S.-led bout of reflation leading to stronger growth outlooks globally. Recent upside surprises in European growth and inflation confirm the positive GPS signals. We believe European equities should benefit in such a reflation scenario, absent any other shocks.

European earnings have historically been more sensitive to global economy pick-ups than U.S. counterparts, given European firms’ lower margins and large revenue exposure to global and emerging markets (EM), our analysis shows.

Yet economic and political shocks have kept investors overly cautious toward European equities, in our view. We believe the political risk priced into European markets around upcoming French and German elections is overstated. A likely Italian election may prove to be a populist flashpoint, but the major risk to our view is that a global slump cuts short the reflation trend. Our GPS data imply this is an unlikely scenario in the near term.

Elsewhere, we have cut EM debt and Asian fixed income to neutral from overweight. We see long-term opportunities in EM bonds, but higher valuations give us pause today. We favor EM equities and European stocks that benefit from global growth including EMs.