European equities priced for disaster, HSBC sees opportunity for patience

European equities are valued for a sharper slowdown than looks likely, said strategists at HSBC, but investors should keep their powder dry for further falls first.

With the third-quarter earnings season getting off to a sluggish start, there is a risk that European corporate growth will begin to fade, HSBC's Daniel Grosvenor said in a note to clients on Friday.

Share valuations have de-rated sharply but "we believe they are pricing in too sharp a slowdown in growth", he said.

Europe’s 12 month forward PE has fallen to just 12.8x, its lowest since late 2013 and well below the long-run average of 14.5x, and with valuations pricing in a significant slowdown in growth.

This is should keep their powder dry for now, though, Grosvenor cautioned, as the average market correction is around 15%, and with European equities down just 10% from their peak "there could be further to go".

But once that sell-off passes through, HSBC's base case points to valuations above current p/e levels, based on earnings growth estimates for 2018 to 2020 and assuming a nominal growth rate of 4% in perpetuity, and a long-term gap of 1% between the return on equity and cost of equity. HSBC suggests that European equities are circa 10% undervalued – pointing to a ‘fair’ 2019 PE of 13.7x.

He continues to favour US stocks where he see fewer downside risks to earnings, and we remain defensively positioned within Europe.

"Drilling down, Energy is one of the only sectors still seeing net upward revisions to earnings estimates, and we believe this continues with the oil price remaining elevated," he wrote. "The flip side to this is further margin pressure, and an ongoing squeeze to consumer spending. We are underweight consumer discretionary names."