BofA sees signs of slowing bullish momentum in European stocks

Bank of America (BofA) analysts warned in a note Friday that the recent rally in European stocks might be losing momentum, citing a shift in the underlying drivers.

"While global equities have rebounded from their mid-April lows, there has been a notable shift in the underlying drivers, with the move no longer driven by declining risk premia, as it had been for most of the past year," BofA notes.

Previously, a decrease in the equity risk premium (ERP), which represents the extra return demanded by investors for holding stocks compared to bonds, fueled the rally.

BofA attributes the recent gains to a combination of rising earnings per share (EPS) driven by strong global growth and falling real bond yields due to subsiding concerns about Q1 US inflation. However, they expect this trend to reverse as growth cools and hopes of an AI-powered productivity boom fade.

"The equity risk premium (ERP) reliably declines in periods of accelerating global growth, but stronger growth explains only part of the ERP compression over the past 18 months," BofA explains.

BofA remains negative on European equities and says it is underweight cyclical sectors compared to defensive ones.

"If the growth weakness intensifies, as we expect, it would be consistent with 15% downside for the Stoxx 600 by Q1 as well as 12% further downside for cyclicals versus defensives," BofA concludes.

They acknowledge that a scenario where inflation subsides before growth weakens could lead to a temporary rally on the back of lower interest rates. However, this would likely be followed by a reversal as growth concerns widen the risk premium.