BNP AM

The sustainable investor for a changing world

Asset allocation update – A deeper short in European equities

In light of the greater downside risk to company earnings in Europe as well as the prospects of rising interest rates and a recession, we have ‘doubled down’ on our previously modest underweight position in European equities, while maintaining a conservative view on taking investment risk.  

Reasons to be fearful

We believe there is greater potential for earnings to disappoint in Europe than in the rest of the world, which is not yet reflected in equity valuations. Another factor clouding the prospects is that discount rates are expected to rise quite markedly in Europe. The European Central Bank’s policy focus has shifted towards tackling inflation, notwithstanding the already pronounced downside risks to economic growth.

A third reason for the larger underweight is the impact from the conflict in Ukraine which we see as particularly intense for Europe’s cyclically geared and geographically close companies.

Lastly, analyst forecasts are calling for barely positive growth in second quarter 2022. This leaves Europe arguably closer to recession, certainly versus the US. There would be a larger knock on impact on corporate earnings given the high operational leverage of European companies.

Risks to future consumption – and growth

In the US, consumption has been broadly resilient so far. However, the 30-50% increases in inventories at US bellwether retailers such as Walmart and Target suggest that demand has moved on from where they expected it to be. Persistent and high inflation is a clear risk for future consumption, further complicating central banks’ ability to tighten policy without slowing growth too much.

Put differently, a soft landing looks more tenuous the longer current conditions last. This has been reflected in the notable flattening in yield curves in Europe and the fall in US breakevens in recent weeks. Liquidity conditions in fixed income, particularly European credit, have been challenging, although in European investment-grade, the spread widening has been indiscriminate.

Asset class views as of 7 June 2022

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