Investing.com -- Morgan Stanley is advising clients to remain cautious on European equities, urging them to "fade the recent bounce" and focus instead on more defensive areas of the market.
According to the bank’s strategists, despite the rebound, valuations do not fully reflect the risk of a recession or a material slowdown in growth.
"European equities have 'travelled' about a third to half of the way to pricing a moderate recession/material growth slowdown," strategists led by Marina Zavolock wrote, warning that markets are far from pricing in a more prolonged downturn.
They point to downside risks of 7% in a moderate bear case and as much as 22% in a full bear scenario. “Notably, our economists new forecasts correspond more to our full bear case scenario,” strategists said.
Morgan Stanley has conducted a detailed bottom-up analysis across about 550 companies, assessing factors like cyclicality, pricing power, and exposure to U.S. policies. The results show that traditional labels of ‘defensive’ or ‘cyclical’ may be outdated in today’s environment.
Instead, Defence, Utilities, Software, and Telecoms stand out as the most resilient sectors based on their fundamentals.
German defense companies like Rheinmetall (ETR:RHMG) and BAE Systems (LON:BAES) rank among Morgan Stanley’s top picks. "Defense remains our preferred sector in Europe," the strategists said.
In contrast, cyclicals such as Semiconductors, Autos, and Construction materials are seen as most vulnerable.
Adding to these concerns, Morgan Stanley's team expects earnings season to bring further disappointment. Of the 150 European companies previewed, strategists expect around 40 to miss earnings or key KPIs, with cyclical sectors most at risk.
Earnings revisions have already started to trend lower, and the strategists project a “sizable skew to further downside.”
While stocks with high U.S. exposure have recently outperformed, the Wall Street firm is skeptical this trend will last. “European stocks with high US exposure have begun to recover of late – we would fade this tactical rebound,” they wrote.