European stocks have been on a tear in recent months, rallying hard on the back of reduced political risks and strong economic data, making assets across the region more attractive than most.
From the beginning of the year, the German, French, Italian and Spanish markets have rallied 8.3%, 5.7% and 9.8% respectively, mirroring similar gains across the region.
However, the golden run for European stocks is about to come to an end, says Deutsche Bank’s equity strategy team, noting that after 15 consecutive weeks of net inflows to the region, the longest stretch since late 2015, investors began to sell last week following a shift in rhetoric from several leading European Central Bank officials.
“The shift in tone of central banks caused Euro area real bond yields to rise by 30 basis points from their mid-June trough, causing equity and bond markets to selloff,” the bank says.
And while that kicked off renewed profit-taking among investors, Deutsche says that several headwinds are likely to emerge in the period ahead that should slow inflows to the region further.
“The run had mostly been a combination of past European market strength as well as reduced political uncertainty, but in its later stage was supported by considerable US equity fund redemptions, as US macro surprises fell to a six-year low,” it says.
“Now however, US surprises look to have bottomed out, removing the tailwind for non-US regions, while at the same time we expect Euro area macro surprises to turn negative, weighing on Europe’s equity flow momentum.”
These two charts from Deutsche help to explain why European stocks have fared so well recently, and why it expects that trend to reverse.
The first shows the inverse relationship between US economic data surprises and net inflows into stocks outside of the US over the past few years. Deutsche has flipped the US macro surprises scale to show the relationship between the two.
As US economic data continued to underwhelm earlier this year, net inflows into stocks in other markets increased, including into Europe. However, as Deutsche alluded to above, US economic data is showing tentative evidence of turning positive, hinting that inflows into other markets may slow as capital flows back to US stocks.
The second chart is similar to the first, only it looks specifically at relationship between European economic data surprises and stock flows to the region.
As European data moved from being dire to delightful from the middle of last year, inflows to the region accelerated, helping to propel stocks higher. As Deutsche indicates, however, it expects that European data will start to undershoot in the period ahead, something that would usually act as a headwind to inflows to the region.