China News Boosts Outlook for European Cyclical Stocks: Citi

Chinese authorities have implemented several significant measures to bolster the economy, including cuts to policy rates and reserve requirement ratios, as well as initiatives designed to lower mortgage rates for first and second homes, according to analysts from Citi Research.

A new facility to support the equity market has also been established. While some of these changes, such as the rate cuts and adjustments to mortgage terms, were anticipated, others were unexpected. Notably, the proposed 25-50 basis point reduction in the reserve requirement ratio (RRR) and the easing of down payment requirements for second homes took the market by surprise.

These initiatives, along with newly introduced equity market support measures, have prompted a rally in Chinese and China-exposed stocks. However, Citi economists warn that these policy measures alone may not be sufficient to change China’s long-term growth trajectory. The main issue lies in weak credit demand rather than liquidity constraints, indicating that stronger fiscal support may be necessary to significantly improve the growth outlook.

Citi economists continue to project a growth forecast of 4.7% for China in 2024, suggesting that Beijing’s GDP growth target is at risk. Despite this, the recent developments have slightly shifted the risk balance towards sectors that are more cyclically sensitive.

In Europe, this shift holds particular significance for industries with strong connections to China. European stocks tied to China have been under considerable pressure throughout the year, lagging behind both the broader indices. Key sectors, including luxury goods, technology, automotive, and basic resources, have faced declining earnings and valuations.

Citi’s analysis indicates that earnings expectations for European stocks sensitive to China have been revised down by approximately 10% for 2024, which is five times the decrease observed in the broader market. Additionally, forward price-to-earnings ratios for these stocks have fallen by about 7%, in contrast to a rise seen in the overall market. A stabilization in China could provide relief to these sectors, positioning them as promising candidates for recovery.

A noteworthy aspect of Citi’s analysis is the contrarian signal from the significant earnings downgrades. Their proprietary Earnings Revision Index (ERI) for European stocks has decreased to -39%, while the index for cyclical stocks has dropped even further to -50%. Historically, such extreme negative readings have often been followed by market rebounds. On average, the index tends to increase by 13% in the year after falling below -40% on the ERI, with cyclical stocks outpacing defensive ones by around 10% during the same period. This indicates potential upside for cyclical sectors in Europe despite recent challenges.

Rate cuts, both in Europe and globally, typically support equity markets, particularly outside of major recessions or financial crises. Cyclical stocks have historically outperformed their defensive counterparts during periods of monetary easing. As central banks, including the Federal Reserve, adopt a more accommodating approach, cyclical sectors could reap benefits from the favorable environment. Seasonal trends also tend to favor cyclicals as the year ends, adding further momentum to this outlook.

In light of these conditions, Citi has adjusted its European sector strategy, adopting a more balanced approach. They maintain overweight positions in defensive growth sectors such as technology and healthcare while selectively increasing exposure to cyclical stocks. Recently, Citi upgraded the automotive sector to a “neutral” rating, reflecting improved sentiment regarding China’s policy support. Basic resources have also been upgraded to neutral, as the prospects for stabilization in China improve the outlook for commodities.

Conversely, Citi has reduced exposure to more defensive sectors, downgrading food and beverages and moving telecommunications to an underweight rating, as these areas face challenges relative to the improving cyclical environment. Analysts remain cautious about China’s overall growth outlook, emphasizing that without greater fiscal intervention, the economy may continue to encounter obstacles. Nevertheless, the recent wave of policy easing, while not transformative, brings a measure of optimism that could be particularly advantageous for European cyclical sectors.