Investing.com -- European equities are poised for a pullback after a sharp rally driven more by sentiment than fundamentals, according to BCA Research.
The investment research firm argues that the divergence between European and U.S. equity markets has become excessive and is unlikely to persist in the coming months.
The Euro Stoxx 50 has outperformed the S&P 500 by roughly 20%, fueled by optimism over a potential low-inflation boom in Europe and concerns about U.S. stagflation. However, BCA warns that Europe’s perceived decoupling from the U.S. is not sustainable.
“A correction in European equities is imminent, creating a better entry point for long-term investors,” said Mathieu Savary, Chief European Strategist at BCA Research.
Savary highlights that Europe remains deeply linked to the U.S. economy, particularly through trade. With the U.S. still its largest export destination, any downturn in American growth would quickly ripple across the continent.
He also points to weakening Chinese credit growth, which limits the potential for offsetting demand from Asia.
Moreover, the recent fiscal stimulus in Germany—totaling €900 billion over ten years—is already priced in by European equities, and further catalysts appear limited.
“The fiscal stimulus story is well covered and well known. Meanwhile, no new announcements for the foreseeable future,” Savary notes.
At the same time, tighter financial conditions and a stronger euro are likely to weigh on economic activity. “With rising optimism toward the Eurozone, generating positive economic surprises is becoming challenging,” the strategist added.
Savary stresses that the recent outperformance of European equities is largely driven by multiple expansion rather than earnings growth. He notes that market momentum indicators show the Euro Stoxx 50 is as overbought as it was only once before since the global financial crisis, a period that was followed by a sharp correction.
A similar pattern is evident in the German DAX relative to the S&P 500, suggesting a potential pullback is likely.
Savary sees particular vulnerability in sectors that led the recent rally. Defense stocks, in particular, are flagged as overbought and now undergoing a correction.
Germany’s market, which has been one of the region’s best performers, is also flashing warning signs as its decoupling from U.S. industrial indices appears unsustainable.
As such, BCA recommends underweighting European equities over the next three to six months and favors defensives over cyclicals. While the long-term view on European assets remains constructive, the near-term setup has turned more fragile.