Graham Secker: Easing Europe’s Stagflation Concerns

Investors appear nervous about the economic outlook as 3rd quarter earnings season approaches. Are stagflation concerns justified… or perhaps overdone?

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Welcome to Thoughts on the Market. I'm Graham Secker, Morgan Stanley's Chief European Equity Strategist. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about why we think the current stagflation concerns in Europe are likely overdone. It's Tuesday, October the 12th, at 2:00pm in London.

In early September, we argued that investors should reengage with cyclical value stocks ahead of a likely stabilization in macro sentiment and in anticipation of higher bond yields. At this time, the former catalyst is yet to occur, however the latter has prompted a sharp bounce in value stocks, which we think has further to run - this would be in line with our bond strategists target of 1.8% on US 10-year yields by the end of this year. Interestingly, the rally in European value so far has been concentrated in the more disrupted names where specific catalysts have boosted performance - such as the rising oil price lifting energy stocks and higher bond yields boosting financials. In contrast, the more traditional cyclical sectors have been modest underperformers, suggesting to us that investors still remain nervous about the global economic outlook.

In recent weeks, this nervousness has taken on a stagflationary tone, with equity and bond prices both falling. In particular, the extent and speed of the rise in interest rates and commodity prices, especially gas and oil, has provoked incremental concerns around the outlook for corporate margins, household disposable incomes and the risk of demand destruction. These concerns are unlikely to dissipate overnight, however we think there is a good chance that stagflationary fears and supply chain issues will start to ease through the fourth quarter, which should allow cyclical shares to rally alongside the value names.

If we are wrong and stagflation concerns grow further from here, then we'd expect to see consumer confidence fall sharply, yield curves start to flatten, and defensives outperform. So far, none of these are happening, even in the UK where stagflation concerns are most acute, and the Bank of England is sounding hawkish on the potential for future rate hikes.

Away from the economic data, the other major concern weighing on European investors just here is the upcoming third quarter reporting season, which will start in the next couple of weeks. After three consecutive quarters of record profit beats, we expect a more modest outturn this time, however one that is still more good than bad. In contrast, we think investors are more cautious, especially around the ability of companies to protect their margins by passing on higher input costs to their end customers.

While some businesses will no doubt struggle in this regard, we believe that the majority of companies will be able to manage the situation well enough to avoid a margin squeeze. Rising input costs are a problem when top line growth is modest and corporate pricing power weak - however, this is definitively not the case today. For example, the latest CBI survey of UK manufacturers show total order volumes and average selling prices at 40-year highs.

At the current time, equity markets still feel fragile and could remain volatile for a few more weeks yet. However, as we move through the fourth quarter, we'd expect an OK earnings season, coupled with evidence that the worst of the third quarter dip in the US and China economies are behind us, to ultimately send European equity markets higher into year end. Our key sector preferences remain unchanged at this time. We like the more value-oriented sectors such as financials, commodities and autos, and are more cautious on expensive stocks in an environment where higher interest rates start to encourage investors to become more valuation sensitive going forward.

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