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Europe stock rally running out of steam: Morgan Stanley

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European shares may be the consensus pick for strong gains in 2014, but Morgan Stanley has downgraded the region's equities to Neutral, expecting them to run out of steam.

While the bank prefers developed markets' stocks over their emerging market peers, it believes Europe's risk-reward profile is the worst among its peers Japan and the U.S., both of which it rates at Overweight.

"Europe remains under the threat of prolonged stagnation as deflation and low growth are likely to become entrenched in the absence of vigorous action from European policy makers," it said in a note, calling its concern "Japanification," a reference to the long economic stagnation in Japan.

(Read more: European shares to double within five years: Barclays)

Morgan Stanley also expects further rises in European equities' price-to-earnings ratios will be limited, as they are already at a 12-year high compared with the MSCI World All Countries index.

It noted that over the May-to-September period, the selloff in emerging market currencies spurred flows into developed markets, particularly Europe.

"This drove European asset valuations up, while at the same time European corporate earnings have disappointed, credit is contracting and leading indicators have rolled over," the bank said.

(Watch: Risk of complacency in euro zone: S&P)

It raised its 12-month forward price-to-earnings target to 13.6 times from 12.5 times, compared with a current reading of 13.1 times, and set a base-case MSCI Europe target of 1500 for the end of 2014, compared with the current level around 1335.

The bank also downgraded European credit markets to equal-weight from overweight, switching its preference to U.S. credit.

For corporate bonds, "Europe's better credit environment is now in the price," it said, citing richer valuations and a weaker growth outlook. "We are cutting our exposure with valuations looking 'average,' fundamentals weakening, and relative pricing richening."

But it still sees some value in peripheral sovereign and corporate credit, believing they are still pricing in "excessive risk of the world ending."

It likes high-yielding European peripherals, such as Greece, Portugal and Slovenia, citing an improving macro trajectory.

"The ongoing support by the Troika should partially ring-fence Greece and Portugal (and potentially Slovenia) from global funding constraints."

For European sovereign bonds, Morgan Stanley said in a bear-case scenario, if the fiscal situation deteriorates, it could trigger rating downgrades and forced selling by index followers.


(Read more: Why Europe may not get much cheaper)

"Italy and France are the two sovereigns we worry the most about, but none is immune. Even Spain, which has achieved impressive productivity gains, is vulnerable due to high unemployment and household leverage, plus sensitivity to global demand as it looks to grow through exports," it said.

To be sure, Morgan Stanley's view appears to be counter consensus.

Institutional investors are heading toward European shares, with 30.9 percent of long-only and hedge funds choosing continental Europe as their favorite developed equity region in a November survey at a conference in Beijing, conducted by Bank of America-Merrill Lynch.

In addition, Barclays recently said it expected European shares could double within five years, with a 27 percent total return likely by the end of 2014, bringing stocks back to their 2007 highs. HSBC is also positive, saying it had seen no signs that retail and mutual fund investors had yet moved aggressively into European equities.

—By CNBC.Com's Leslie Shaffer; Follow her on Twitter @LeslieShaffer1

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