This year's most popular "no brainer" trade is turning into a bit of a head-scratcher. "Buy Europe" has turned out to be a relative winner for 2015, with pan-European equities up some 4.6 percent this year against a 2.6 percent decline for top global stocks. Fund managers are still backing the trade even after disappointing earnings growth and worries over lofty valuations.
But some have seen distant warning signs, such as rising turbulence in high-yield credit markets across the Atlantic, driven by a rout in commodity prices and an imminent rise in US interest rates. They say those signals may be a better clue to how European stocks will fare next year. To be sure, there are clear differences between high-yield corporate credit in the United States and Europe. The former is exposed to a commodities sector financed in US dollars, and its default rates are expected to reach 4.5 percent in 2016, according to Fitch. Europe's defaults are seen below 1 percent.
And fund managers are clearly taking a benign view. A net 55 percent of investors surveyed by Bank of America-Merrill Lynch are overweight euro-zone equities, contrasting with overall net underweights on US stocks. Euro zone stocks were rated only the sixth-most crowded trade, below US high yield. However, there are also important connections. They suggest Europe probably cannot decouple itself entirely from a US market that looks vulnerable after more than six years of virtually uninterrupted stock market gains.
For one thing, any rising pressure on bond investment funds to meet investor redemptions - as seen recently with the meltdown of Third Avenue's $789 million fund - is likely to have global knock-on effects. Selling assets or hoarding cash would probably see investors turning more cautious on non-US assets as well.
"The thing about financial markets is they are all absurdly interlaced," said David Jane, multi-asset fund manager at Miton. "If you're a US bond fund and you've just seen a big part of your portfolio take a hit, will you really feel inclined to lend to another issuer on the same terms as before?" European markets have already run into pockets of stress. They remain isolated cases for now: Spain's Abengoa and France's Vallourec, are among the poorest European bond-market performers and are down 80 percent and 60 percent respectively on the stock market as well.
Shares of telecoms company Altice have fallen more than 20 percent this year as investors grew wary of its debt-fuelled expansion. Any ripple effects of rising debt costs should also give pause for thought regarding lofty market valuations, even with the ECB committed to monetary stimulus to spur economic growth. Worldwide merger activity is at record levels and helping buoy financial markets - that may very well change. "If debt costs rise then debt service ratios will deteriorate ... Enterprise value as implied by the public equity and M&A (mergers and acquisitions) markets may come down," said Ed Eyerman, head of European leveraged finance at Fitch. So where does that leave the bull case? Despite some disappointment this year, profit growth remains the main plank supporting "Buy Europe" optimism. Asset-manager Amundi said the combination of cheap oil and better economic momentum would lead to a 12 percent increase in euro-zone earnings per share next year. But optimists should be prepared for a rapid reversal. Goldman Sachs has already called European equities "fully valued" and debt fears are spreading beyond commodities. "The lesson from the past is that things change really quickly," said Miton's Jane.