Listen as our strategist cites which present-day factors and historical precedents should have investors expecting a big year in European equities.
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Welcome to Thoughts on the Market. I'm Marina Zavolock, Morgan Stanley's Chief European Equity Strategist. Along with my colleagues bringing you a variety of perspectives, today I'll be discussing our new approach to European equity markets. It's Friday, January 26th at 4:00 pm in London.
My team and I recently launched coverage of European equities, with a goal of offering investors a more dynamic and modern approach to stocks in the region. Bottom line we're bullish on European equities and see 11% upside to our year end target for MSCI Europe. This rises to 16% on a total return basis if we incorporate dividends and buybacks. Let me walk you through our thinking.
We seek to bring traditional equity strategist to the modern data era by blending traditional European equity strategy metrics such as a focus on PMIs, valuations, flows, etc., with bottom up data driven analysis, unconventional factors, an in-depth cycle playbook and integration of important thematics such as AI diffusion, the rise of European M&A and geopolitics.
For our cycle playbook, we worked closely with our global economics team to determine which specific cycle in long term history is most similar to today. Our work led us to the mid 1990s and specifically 1995, a soft landing in the US and a soft-ish, still very weak growth environment in Europe. This was a period where there was a major focus by market participants over rates and inflation, bad macroeconomic data was seen as good given its implication for future rate cuts, and there was an undercurrent of technological innovation. Other similarities included overoptimistic market pricing on fed rate cuts after the pivot, a later pivot from European central banks, and concerns about deficit reduction and a budget deal in the US.
After an initial sharp Fed pivot related rally, there was a tactical pullback in 1995 in the market, and at this point leadership changed. From a bond proxy leverage cyclical driven rally, very similar to the one we saw into year end, to a rally driven more by idiosyncratic stock specific fundamentals and themes. At the headline level, the market continued to grind higher on the hope trade of future rate cuts and nearing bottom to earnings revisions, and the eventual return of flows into equities from money market funds. Like 1995, we are also seeing a return to M&A from cycle lows, which should further support this rally. Notably, Europe's low valuation starting point and rerating path so far is exactly in line with the 1995 Fed pivot playbook.
From a factor perspective and to uncover that stock specific, idiosyncratic alpha, I mentioned earlier, we studied over 80 different factors or metrics and uncovered ten that work sustainably to drive relative performance in European equities over time. These range from the conventional, like earnings revisions to the unconventional, such as accruals, an accounting measure that works very well in Europe to predict future earnings quality.
Bringing everything together, our cycle, factor and thematic analysis, we arrive at 16% total return upside to European equities this year and overweights on European software, aerospace and defense, diversified financials, pharmaceuticals and telecoms, among other sectors.
Thanks for listening. If you enjoyed the show, please leave us a review on Apple Podcasts and share Thoughts on the Market with a friend or colleague today.
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