European shares, already trading near record levels, only took a brief dent when the ECB released cautious comments on inflation and its expected rate cut trajectory on Thursday. The central bank had just cut interest rates, as widely expected, and traders were focusing on cues about how many more rate cuts to expect in 2024.
The ECB's raised inflation forecast cooled hopes for a further cut in July, which markets had already assigned a low likelihood of about 10% before the announcement. Throughout the central bank's initial statement and subsequent press conference, President Christine Lagarde refused to say whether the institution had embarked on a rate-cutting trajectory for the remainder of the year.
For Michael Field, European markets strategist at Morningstar, "the question of whether further rate cuts will follow in 2024 is still open to debate. Most economists think so. I would tend to agree, inflation has come down enough to justify it, and interest rates at current levels give the ECB plenty of room to cut without fear of a resurgence of inflation," he explains.
Why are European Equities Near Record Levels?
Between the start of the year and the time the ECB started cutting rates, European equity markets had risen by almost 9%.
This rise can be explained by earnings estimates for European equities, which have been revised upwards by 2.8% since the start of the year, and the appreciation of the valuation multiple (P/E), which has risen from 13x to 13.8x. At this level, it is slightly below its historical average of 14x.
"Historically, European equity markets were up in 9 out of 11 cases 12 months after the first cut and on average by 20%," Deutsche Bank strategists commented on Friday. "Different to today, most of the past cutting cycles started while the economy was in a recession. This time around, markets are enjoying the benefit of rate cuts while economic growth is picking up and inflation has normalized – a Goldilocks scenario."
BDL Capital Management fund manager Laurent Chaudeurge also sees further upside if economic trends persist: "The feedback we're getting from companies shows that last year's destocking movement is over. Results for the second quarter of 2024 were better than those for the first, but we haven't yet seen a very marked recovery," he told Morningstar on Friday. "We therefore need the second half of the year to validate this recovery, and for earnings to continue to grow in the second half, which should benefit from a favourable basis of comparison with the second half of 2023."
Which Sectors Could Benefit from Further Rate Cuts?
To answer this question, the recent sectoral performances of the European equity markets may give an indication, since Thursday's rate cut was already priced into valuations.
Among the sectors that have gained the most this year are financials and telecoms, which are more sensitive to rate cuts, but also technology and industrial stocks, which are more sensitive to the outlook for economic growth.
"The prospect of a more favourable macro environment should benefit equities in general, and cyclical sectors such as industrials in particular," Julius Baer strategist Mathieu Racheter and analyst Christian Gattiker wrote in a May 31 note.
Deutsche Bank's strategists favour Basic Resources and Chemicals stocks, which "still leave potential for further upside due to improving global manufacturing activity." Meanwhile, "Staples and Residential Real Estate offer the biggest upside" with regards to interest rate sensitivity.
Why Didn't Equities Jump After Thursday's Rate Cut?
"Clearly, a cut of 25 basis points is not enough to move the needle on economic growth, or even to materially reduce debt servicing costs for European-based companies," says Morningstar's Michael Field.
"That said, this cut is symbolic of a change of direction on the part of the ECB. The idea of returning to a more normalised interest rate environment, where base rates stabilise at something like 2%, is enough to excite equity markets."
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