The European Central Bank building in Frankfurt, Germany. Picture: iSTOCK
The European Central Bank building in Frankfurt, Germany. Picture: iSTOCK

London — Europe is the epicentre for recession fears — but investors are cheering.

The continent’s biggest companies have started to outperform their US peers on a forward-earnings basis, the cost of insuring against corporate defaults has fallen this year, and traders are betting that volatility will decrease.

What makes this pivot towards optimism striking is that it runs against recent data. From flagging industrial output in Germany and France to worsening consumer confidence, official measures seem to indicate the economy is facing a rough patch. Investors have so far resisted the downward pull of bad macro-news, possibly because they expect corporate results to tell a different story.

“There’s value in European equities,” said Chris Bailey, a European strategist at Raymond James in London. “I think European corporate earnings are going to beat the US. this year because the US’s late-cycle, tax-cut benefits are rolling off and earnings are coming down from a very high base.”

Valuations for European shares, based on expected earnings, lagged their US counterparts for most of last year — but the mood started to shift in December with the ratio between the two metrics hitting the highest level in more than two years. It remains elevated compared with recent readings.

And options traders are taking a similar bet. Implied volatility has dropped below historic volatility, according to data compiled by Bloomberg. That’s the first time it’s happened since August, and could be a sign December’s wild swings are a thing of the past.

“Eurozone assets, on top of being cheap, have benefited from the improved sentiment,” said Sophie Huynh, a cross-asset strategist at Société Générale in London. This partly reflects hopes of political calm, with “Yellow Vests” protests easing in France, Italy’s budget no longer dominating headlines, and signs of a thaw in the trade war between the US and China.

The improved sentiment has seen investors rotate back into cyclical stocks, with an index tracking their performance rising at the fastest pace since 2016.

Not all is rosy, though. The soft data may temper the European Central Bank’s (ECB) ability to raise interest rates in the fourth quarter. That may put a drag on banks and the euro. JPMorgan Chase pushed back its hike forecast by three months to December.

Yet look to corporate debt markets, and fear seems to be on the wane. Credit-default swap indices are tightening this year, in marked contrast to 2018’s surge, signaling investors see credit risks dissipating.

“We got the Italian budget deal and slightly friendlier sentiment overall,” said Marco Stoeckle, head of corporate credit research at Commerzbank. “Plus, the earnings season will start soon.”

With assistance from Tasos Vossos and James Hirai

Bloomberg