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.
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.
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."