The shadow of recessionary rate cuts looms, is the logic of the European stock market bull market facing reevaluation?
The cooling of the U.S. job market and the political pressure faced by the Federal Reserve may prompt a shift towards "bad rate cuts." European stock markets are facing challenges of logical reassessment. A report from Bank of America indicates that the July non-farm payroll data has been significantly revised down, with the three-month average job growth dropping to 35,000, lower than the same period last year. European stock markets are expected to face a 10% correction pressure, and whether a low interest rate environment can drive European stocks up depends on the nature of the rate cuts. Bank of America analysis suggests that if rate cuts are due to falling inflation, it may support market gains; conversely, it may lead to a stock market decline
The cooling of the U.S. labor market and the political pressure faced by the Federal Reserve may prompt a shift towards "bad rate cuts." With European stock market valuations high and profits peaking, the market faces challenges of logical reassessment.
According to the Chase Wind Trading Desk, Bank of America's latest report points out that the U.S. labor market has significantly slowed down, with the July non-farm payroll report drastically revising employment data for the previous two months, bringing the three-month average job growth down to only 35,000, far below last year's level. This has raised concerns in the market that the Federal Reserve may be forced to implement "bad rate cuts"—that is, rate cuts in response to the deterioration of the labor market rather than a decline in inflation. Bank of America expects European stock markets may face a correction pressure of around 10%, with defensive sectors likely to benefit.
Meanwhile, Bank of America's interest rate strategists have turned more optimistic about U.S. Treasuries, expecting that weak employment data and the increasing influence of the "low-rate faction" within the Federal Reserve's decision-making body will drive bond yields further down. In the context of slowing economic growth, the decline in bond yields will translate into downward adjustments in profit expectations and valuation multiples, leading to a drop in the stock market.
Can a low interest rate environment drive European stocks further up?
For the European stock market, the impact of declining bond yields will depend on the nature of the rate cuts.
Bank of America believes that if central banks become more dovish due to falling inflation (i.e., "good rate cuts"), the decline in risk-free rates may not lead to a corresponding rise in risk premiums, thereby supporting market growth. However, if the rate cuts are in response to labor market and broader economic weakness (i.e., "bad rate cuts"), this would not align with maintaining risk premiums at their current compressed levels.
In fact, during periods of economic slowdown, in scenarios of declining real bond yields, risk premiums not only rise but typically rise more than the decline in real rates, which explains why stock market valuation multiples often decrease rather than increase during economic slowdown phases.
Therefore, although the decline in real bond yields is beneficial for the European stock market, Bank of America analysts believe that in the context of slowing economic growth, the decline in bond yields will translate into downward adjustments in profit expectations and valuation multiples, leading to a drop in the stock market.
Bank of America expects that global macro headwinds will lead to a decline in the global composite PMI new orders from the current 52 points to 49 points in the first quarter of next year, indicating a rise in risk premiums and downward adjustments in EPS expectations, with the resulting drag on the market only partially offset by the decline in risk-free discount rates.
In summary, analysts expect that the Stoxx 600 index may face a correction space of about 10%, dropping to 490 points by the middle of the second quarter of next year (year-end target 520 points; DAX index: 22,700 points; FTSE index: 8,750 points). At the same time, it is expected that European cyclical sectors may decline by about 10% from the current 30-year high relative to defensive sectors, value stocks may drop by about 10% from the current five-year high relative to growth stocks, while quality stocks may rise by about 10% relative to the market from the current six-year low
Financial stocks peak, software sector is about to rebound, defensive industries may benefit
Bank of America holds an underweight position on European cyclical industries relative to defensive industries, favoring pharmaceuticals and food and beverage sectors, while being bearish on banks and capital goods.
The report points out that the European financial sector (including banks and insurance) has risen to a 14-year high after a recent strong performance. Interest rate-sensitive assets have not yet reacted to the recent decline in U.S. bond yields, but if rates continue to fall and are accompanied by more pronounced signs of growth slowdown, it may lead to underperformance in these sectors.
Meanwhile, the decline in bond yields should support defensive industries to rebound relative to the market from the current 17-year low, especially in European consumer staples and pharmaceuticals, while the utilities sector has already fully reflected lower rate expectations after a recent strong performance. The real estate sector (with nearly two-thirds of costs being refinancing) also tends to perform well during periods of declining bond yields.
Bank of America has upgraded the European software sector rating to overweight, believing that the sector has become attractive after a 17% decline since February, as lower bond yields typically benefit the valuation of high-growth sectors.
The report suggests that as the 12-month forward EPS and 12-month forward profit margins of European equities approach historical highs, and the European equity risk premium nears an 18-year low, the decline in bond yields has become the only remaining potential positive catalyst after a 45% market rise since 2022 (up 100% since the COVID low in 2020). However, if this rate cut is a "bad cut" in response to recession risks, the logic for market gains will face severe challenges.
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