European Markets Face New Reckoning Threatening More Losses

(Bloomberg) — European stocks and corporate bonds have taken a beating this year. Investors might still be in denial about how much worse it could get.

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Despite the stresses of a devastating energy crisis, surging inflation and central bank policy tightening, stock market valuations remain above levels hit during the Covid-led selloff in 2020 and the 2008 financial crisis.

Such positioning is about to face multiple reckonings, from the mounting energy crunch, a jumbo 75 basis-point European Central Bank rate hike on Thursday — and more ahead — and subsequent downgrades to earnings estimates that strategists at Citigroup Inc. say are coming.

“With a recession hurtling toward us like a riderless horse, it’s clear markets could fall much further,” said Danni Hewson, a financial analyst at AJ Bell. “The big test will come when the earnings season comes around again, giving companies a chance to update shareholders on how they’ve been able to navigate the current inflationary storm and how demand has been holding up.”

European Union energy ministers are due to discuss measures on Friday to ease the damage from the energy crisis. The meeting comes amid warnings that the gas shortages won’t be a short-term issue, and the strain could stretch into future winters.

European stock and corporate bond markets are already collectively having one of their worst years on record. While a combined $4.5 trillion has been erased from regional markets, the pile-up of challenges means there’s probably more ahead.

According to Guy Miller, chief market strategist at Zurich Insurance, even though the coming recession is the “most anticipated we’ve ever had, I don’t think it’s fully reflected in the markets.”

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“From a margin perspective, there’s further downside ahead, meaning earnings revisions have to come a lot lower as well,” he said.

As the pressure continues to build, here are some of the macro and technical elements that will play key roles in the coming market direction.

Energy Crisis

Investors are most worried about the lasting impact from the energy crisis, which is hitting the economy from multiple angles. Surges in prices are squeezing households and companies, while the increased risk of power shortages poses huge risks to industrial-heavy nations like Germany.

The dire situation means measures of economic confidence and surveys of activity — such as the PMIs — continue to deteriorate, and that steady drip-drip of bad news may kick off another round of investment gloom, dragging down asset prices. Economists in a Bloomberg survey see the euro-area economy barely growing this quarter and shrinking in the final three months of the year.

Valuation Risk

European stock valuations have fallen below their long-term average, making regional stocks relatively cheaper to their US peers. But they’re not at previous crisis-period lows yet.

With corporate margins facing their biggest decline in more than a decade, Morgan Stanley strategist Graham Secker says the forward 12-month price-to-earnings ratio for European equities could fall another 15% from current levels.

“When you look at earnings expectations, the market is broadly underestimating the size of the economic shock ahead,” said Hugh Gimber, global market strategist at JPMorgan Asset Management. “Anyone making the case today that equities look cheap, you have to question how much faith you can really place on the ‘e’ in those p/e multiples.”

Not So Bullish Anymore

Investors have turned more cautious since the summer rally fizzled out, with economically linked sectors such as autos, chemicals, banks, retail and industrials underperforming.

European stock funds have seen outflows for 29 straight weeks, and the share of European companies hitting a 52-week low also shows negative investor positioning. Although the selloff hasn’t matched the panic seen in 2020 or even at the height of the global financial crisis, the rout has been more prolonged than in the past few downturns.

While extreme bearishness in positioning can be viewed as a contrarian signal for a rally, Morgan Stanley’s Secker said that’s unlikely this time as the economic outlook hasn’t yet been priced in.

Volatility Spike

Stock markets tend to sustain a rally only after the volatility index has posted a sharp jump, if past meltdowns are any indication. But the selloff since August hasn’t been accompanied by a corresponding spike in volatility.

That suggests “the downtrend remains intact” amid “few technical signs that price action has yet reached a bottom,” said Victoria Scholar, head of investment at Interactive Investor.

In a bright spot, lower volatility does create hedging opportunities as the cost of portfolio protection remains relatively cheap. Germany’s DAX Index is particularly appealing due to its high exposure to the gas shortage and the benchmark’s 40% weighting in energy-intensive sectors such as industrials, autos and chemicals.

Pricey Debt

Another pressure point is access to money, and its cost. Companies’ ability to finance themselves using debt has become harder, and signs point to a further deterioration in market access.

Between central bank tightening, the upward shift in yields and general risk concerns, refinancing borrowings is getting more expensive. The extra interest cost of new bonds over existing ones stands at $2 million for every $100 million, based on data compiled by Bloomberg.

This marks the biggest rise in refinancing costs for euro-denominated high-grade bonds on record. Until earlier this year, replacing old debt with new actually resulted in savings for borrowers.

Amid the increasing pressures, ratings companies have been taking action. Moody’s Investor Service, S&P Global Ratings and Fitch Ratings, have issued more downgrades than upgrades among junk-rated firms based in Western Europe this year, based on data compiled by Bloomberg.

One argument among analysts is that companies have padded their balance sheets since the coronavirus shock, taking advantage of the era of central bank largesse to lock in cheap funding and extend maturities. This reasoning could lose its potency as persistently tough market conditions cause cracks in borrowers’ so-called fundamentals.

“There are a number of reasons to be cautious,” said Colin Fleury, head of secured credit at Janus Henderson. “It will be complacent to think that because we went into this with a relatively healthy funding situation, we aren’t going to see an uptick in stress.”

(Updates with ECB rate hike decision in third paragraph.)

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