European equities are likely to continue lagging the global stock market in 2020, according to analysts, although some investors are predicting that they could rally much stronger than most expect. 
Issues such as the 2011 eurozone debt crisis, lacklustre economic growth and political uncertainty have put investors off Europe for much of the recent past but as we move into the new year there are some signs of improving confidence.
Andrew Pease, global head of investment strategy at Russell Investments, is expecting a gradual pick-up in economic growth across the eurozone during 2020.
“The eurozone should benefit in 2020 from easier monetary conditions, the recovery in global manufacturing, the lifting of trade-war uncertainty and Chinese policy stimulus that increases import demand from emerging markets,” he said, adding that easing political risk and a potential lifting of Brexit uncertainty will also be positive.
Expectations of improved growth and the prospect of a US-China trade deal led analysts at Bank of America Merrill Lynch to tell investors to “stay positive” on European equities. They see the Stoxx 600 as having 8 per cent potential upside by the third quarter of next year.
Estimated Stoxx 600 performance in 2020
Source: BofA Merrill Lynch Global Research estimates, Datastream
When it comes to the German DAX, BofA Merrill Lynch expects 12 per cent potential upside by early Q4, compared with just 10 per cent from the FTSE 100.
However, they added: “We think European equities are set to continue underperforming global equities by 5 per cent next year, as the euro strengthens and the mild improvement in euro area growth momentum we expect is not enough to offset Europe's structural growth underperformance.”
BofA Merrill Lynch analysts have a preference for European cyclical stocks over their defensive counterparts, a view that is shared by James Sym, manager of the £851.7m Schroder European Alpha Income and £242.9m Schroder European Alpha Plus funds.
“Cyclical value looks attractive for a start,” he said. “This means undervalued stocks that are sensitive to the economic cycle. Our view is that we are at a turning point in the cycle, with a more synchronised global recovery expected in 2020.”
The manager follows a ‘business-cycle’ investing approach and a “classic call” in this is to buy economically-sensitive stocks when purchasing managers’ indices (PMIs) – or forward-looking surveys of trends in the manufacturing and services sectors - are low and consensus is pessimistic.
Given that PMIs are currently at the kind of weak levels last seen in the global financial crisis, the business-cycle approach is pointing strongly towards a cyclical tilt for European equities.
IHS Markit Eurozone Composite PMI
Source: IHS Markit, Eurostat
“This takes us to some very unloved areas of the market,” Sym explained.
“We think oil & gas is a sector where there is significant potential, specifically oil & gas services where many businesses are trading on very depressed valuations. However, we believe they could be in the early stages of a recovery with day-rates for rigs improving and oil majors increasing investment.
“Banks are another area we think look compelling. Many have become lowly valued by the market owing to the argument that low interest rates (and correspondingly low bond yields) are squeezing profit margins beyond all hope of a near-term return to significant profitability.
“However, yields don’t need to move a great deal for sentiment to change. We are particularly supportive of those European banks with strong franchises and decent market share.”
Of course, there is the potential for European equities to rally harder than expected, with BofA Merrill Lynch saying a stronger-than-expected growth rebound could see them rise by 13 per cent next year.
In this upside-risk scenario, a comprehensive US-China trade deal allows growth momentum to rebound more strongly than envisaged. But the bank’s downside-risk scenario sees growth failing to strengthen as much as hoped and leads to a 9 per cent drop in the stock market.
Christopher Smart, chief global strategist and head of the Barings Investment Institute, said a “bold” prediction for 2020 would be that Europe starts to outpace the US after its lengthy period of underperformance.
“If some of the headwinds around Brexit begin to clear, which seems to be the direction we’re headed, it would be supportive of the economy as a whole,” he explained.
“The German economy – the biggest in Europe – could also see improvement, particularly if the government provides even a little fiscal support. Finally, any weakness in the US dollar would have the potential to further propel international markets.”