Bank of America outlines how to brace for a 10% drop in European stocks before year-end

Published Wed, Aug 11 202110:35 AM EDTUpdated Wed, Aug 11 202110:42 AM EDT

Sam Meredith @in/samuelmeredith @smeredith19

Bank of America expects a number of downside risks to trigger a sharp pullback in European stocks this year, advising investors to adopt a strategy designed to withstand an "anti-goldilocks environment." It comes as market participants remain wary about the consequences of reaching peak economic growth following moves to relax public health measures amid the ongoing coronavirus pandemic. To some on Wall Street, there are concerns that peak growth in both the economy and corporate earnings, partly driven by a stimulus-fueled recovery, could soon give way to more normalized patterns . "This tremendous acceleration that we have seen over the last 15 months really has generated one of the all-time great equity market bull runs," Sebastian Raedler, head of European equity strategy at Bank of America, told CNBC's Geoff Cutmore on Wednesday. However, Raedler said BofA had recently downgraded European stocks to neutral from positive, citing an expected slowdown in growth momentum through the remainder of the year. "We have around 10% downside into the end of the year but that downside we think will only materialize once the real slowdown starts, which we think will only happen in the fourth quarter," Raedler said. "It helps to understand how did we get here and how are things going to change," Raedler said, noting two risk factors for investors to monitor alongside fading growth momentum. "So, two very important things happened last year. First of all, the growth rate accelerated tremendously … but then equity multiples also got a lot of support from a decline in the discount rate because real bond yields, which is the discount rate for equities, dropped as central banks turned very dovish." A discount rate is a metric used by traders to work out the cost a business faces to finance activity. Raedler described this "goldilocks environment" of higher growth rates and lower discount rates as a "fantastic sugar rush" for equities. Now, however, BofA sees scope for higher discount rates and lower growth rates. "So, you're almost from here, we think, in an anti-goldilocks environment. Instead of having stronger growth and a lower discount rate, over the coming six to nine months, it is very likely you get lower growth and higher discount rates. And obviously, that starts to sound like a rather unappealing proposition." To counter these downside risks, BofA has further reduced its exposure to cyclical stocks, whose performance tends to align with the trajectory of the global economy, by lowering capital goods and raising defensive European utilities to marketweight. The bank says the utilities sector's 20% underperformance since last March leaves its price relative at a two-year low and its Purchasing Managers' Index projections only imply around 5% further downside. BofA said it is overweight on European assets that would benefit from one last leg of rates upside, such as financials and value versus growth, and underweight on bond-proxy sectors such as health care and staples.

People look at food stalls at La Boqueria market on August 5, 2021, in Barcelona, Catalonia, Spain.

David Zorrakino | Europa Press | Getty Images