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Investors go 'overweight' European equities as US recovery stumbles

"Of the major economies, Europe's prospects look brightest."

This statement by Pictet Asset Management in its July investment outlook came as the group raised its exposure to European stocks to overweight, explaining, "eurozone equities have shown significant positive momentum lately. They were cheap relative to the U.S. market before the crisis and continue to look attractive on that basis."

Pictet — with some $183 billion under management — is not alone in talking up European assets. With the coronavirus seemingly under control, the European Central Bank showing willing to provide whatever level of monetary support is required, a swathe of fiscal stimulus by individual members and a €750 billion "Next Generation EU" fund planned by the European Commission, investors are rethinking Europe's prospects.

"Our economists expect a steeper and smoother rebound from the corona crisis in Europe than the U.S. due to better virus control and a much smaller increase in unemployment rates," Goldman Sachs strategists including Zach Pandl wrote in a note.

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U.S. assets have outperformed their European counterparts so far during the economic recovery. The S&P 500 was down just 0.5% for the year at close of trade July 16, while the Euro Stoxx 50 still had 10.1% to make up.

However, the tremendous recovery of U.S. equities leaves "little to no room for negative surprise at a time of looming risks from trade, U.S. elections and second waves of COVID-19," according to Lyxor Asset Management — which also upgraded its position on European equities to overweight — noting in its outlook for the third quarter, "the consensus looks conservative in Europe, optimistic in the U.S."

US virus cases surge

In the EU, governments have been able to relax lockdowns and keep daily new cases of the virus below 10,000 since May 7, according to data from the European Centre for Disease Prevention and Control. By contrast, since mid-June the number of new daily U.S. cases has surged, reaching a record 71,000 on July 16, fueled by outbreaks in southern and western states.

Florida alone had 15,300 new cases July 12 and a total of 315,775 total positive cases as of July 16, according to the COVID Tracking Project. That makes it the third highest of any U.S. state after New York — 404,775 — and California — 356,178 — and exceeds the total for the entire U.K., which is 292,522.

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On July 13, California Gov. Gavin Newsom ordered a statewide shutdown of bars, dine-in restaurants and cinemas, joining Texas and Arizona in reversing the reopening of its economy.

The decision contributed to a sharp drop in U.S. equities, with the S&P 500 closing down 1% having been up 1.5% earlier in the day.

"In GDP weighted terms, 60% of the states have delayed their reopening or rolled back some relaxation of the containment measures. It is starting to show," Gilles Moëc, chief economist at Axa Investment Managers, wrote in a research paper.

The EU is not immune but outbreaks in the 27-member bloc have been smaller and more localized.

On June 23, an area of Germany saw lockdown reimposed following an outbreak in a slaughterhouse, while on July 5 a spike in cases saw the Spanish government place stringent measures in the northwestern Galicia region. While in Greece the government has warned of reintroducing lockdown after a number of new cases related to the reopening of its doors to tourists.

New cases in the EU totaled 4,905 on July 11.

"Continental Europe is starting to 'look better' than the U.S., reversing the picture which prevailed in the spring," Moëc wrote, noting, "the Q3 rebound looks more assured in Europe, as the pandemic continues to be in much better control than in the U.S."

Coming out of lockdown

Major macroeconomic indicators have thus far signaled a V-shaped recovery of sorts on both sides of the Atlantic.

U.S. retail sales climbed 7.5% in June, beating the 5.5% consensus and building on growth of 17.7% in May. In the EU retail sales surpassed expectations in May climbing 16.4% after falls of 9.8% in March and 11.4% in April.

Industrial production has also broadly followed a V-shaped trajectory.

In the U.S., output rose 5.4% in June, building on the 1.4% increase in May, with auto production leading the way with a 105% month-over-month increase. Yet auto output is still down 25% on 12 months ago and, at 68.6%, total industrial capacity utilization is at historically low levels.

Industrial output in the 19-member eurozone increased 12.4% in May following a 42% month-over-month increase in Italian output and a 20% gain in France, short of Oxford Economics' forecast of 15%. German output disappointed with a 10% increase, though the ZEW economic sentiment index improved for the fourth-consecutive month in July to 59.6, its highest reading since May 2015 and up from 58.6 in June.

Reopening interrupted

However, real-time economic data shows the U.S. recovery running out of steam. The JEF Economic Activity index, developed by U.S. investment bank Jefferies, has started contracting after moving sideways for several weeks.

"Regional data show particular weakness in the Sun Belt, but there are also some worrying signs in the Midwest, where cases are accelerating and activity is leveling off," Aneta Markowska, chief financial economist at Jefferies, wrote in a July 13 note. "The slowdown is unlikely to impact June data, but July data are clearly at risk."

Unemployment disparity

Whereas the EU unemployment rate rose only slightly from 6.4% in March to 6.7% in June as European governments unveiled massive job retention schemes — with the rate actually falling in countries such as France and Spain — the U.S. took a different strategy, allowing jobs to fall and hoping a dynamic economic recovery would mean people are quickly rehired.

While the rebound happened faster than expected — non-farm payroll jobs increased by a record 4.8 million in June — U.S. employment remains down 14.7 million on February, and there are concerns that the hiring spree will hit a wall.

"The recreation and hospitality industry, which in normal times accounts for just 11% of the U.S. headcount, contributed 2.1 million — or 44% — to total job creation in June, as restaurants, bars and cultural venues were reopening across most of the country at cut-off date for data collection. This suggests that the next month is not going to be as stellar, with the ongoing rollback in some states affecting the rehiring process," Moëc said.

The ability of the economy to continue to create jobs will be curtailed if the worsening outbreak forces further lockdowns.

"The easing of the lockdowns has generated a bigger rebound in spending in May and June than we were originally anticipating but, given the resurgence in coronavirus infections, the pace of recovery is likely to be slower in the second half of the year," Paul Ashworth, chief North American economist at Capital Economics, wrote in an email.