Is it time to buy European cyclical stocks?

Investing.com -- In recent weeks, European equities have seen a general boost as risk premia, which spiked sharply two weeks ago, have subsided. However, the performance of cyclical stocks in Europe, particularly those exposed to consumer spending, technology, and China, has been weak, said analysts from BofA Securities in a note.

1. Risk premia dynamics

The recent spike in risk premia, driven by disappointing US labour market data, has begun to recede as macroeconomic data alleviates fears of a hard landing. 

This decline in risk premia has generally supported European equities. Yet, cyclical stocks, which are typically more sensitive to economic cycles and risk sentiment, have underperformed relative to defensives.

“While European equities overall have closely tracked the moves implied by their historical relationship with risk premia, cyclicals versus defensives have been notably weaker, leading them to clearly undershoot the trajectory implied by US high-yield credit spreads, the best gauge of global risk premia,” said analysts at BofA.

2. Cyclical sector performance

The underperformance among cyclical stocks is not uniform but concentrated in three primary areas:

• Consumer-Facing sectors: These sectors are facing mounting concerns about labour market stability and consumer spending. The weak economic signals have dampened investor confidence in consumer-oriented cyclicals.

• Technology: The tech sector, particularly those involved in AI investments, has experienced setbacks. Investors are growing impatient with the slow pace at which tech companies are monetizing AI advancements, impacting stock performance.

• China-Facing sectors: Mining and other sectors exposed to China have suffered due to ongoing economic uncertainties in the region.

Conversely, some cyclical segments, particularly those with strong negative correlations to credit spreads, have fared better. Sectors such as capital goods, banks, and construction materials have shown resilience, benefiting from the recent fade in risk premia.

3. Global growth expectations

“We expect a further weakening in global growth as the US labour market continues to soften,” the analysts said. Historically, a rising US unemployment rate has been a precursor to hard-landing economic scenarios. 

Given this, the analysts predict continued challenges for cyclical stocks as economic growth moderates.

4. Outlook for European cyclicals

Analysts at BofA Securities maintain a cautious stance on European equities and cyclical stocks versus defensives. They predict a further decline in the Stoxx 600 Index, with a target of 475 by the end of 2024, reflecting a potential 10% downside. 

Additionally, cyclicals are expected to continue underperforming compared to defensives, with a projected 6% further decline following a 13% underperformance since April 2024.

The sectors most vulnerable to deteriorating economic conditions include:

• Capital goods: Sensitive to shifts in credit spreads, capital goods stocks could face significant pressure if spreads widen further.

• Banks: As financial institutions are directly impacted by credit conditions, any increase in risk premia could adversely affect their stock prices.

• Construction materials: This sector also shows vulnerability to fluctuations in economic sentiment and credit conditions.