Back in April I penned an article calling for a strong recovery in Europe in the last half of 2013 (click for link) with the main drivers for a recovery being monetary and disinflationary stimulus. These leading indicators proved correct back then but are now signalling a pause in the European recovery just as global investors are pouring funds into the region.
European Leading Indicators Signal Pause
What I saw in early 2013 that called for a pickup in European growth later this year was a sharp increase in the annual growth in European M1 money supply (green line below shown advanced). Additionally, financial conditions (as evidenced by the Bloomberg Financial Conditions Index, red line below) had improved which typically translate into better economic growth months down the road. These indicators argued European GDP (black line below) would bottom earlier in the year and then accelerate to close out 2014, as we have seen. However, M1 money supply growth rates have peaked and financial conditions have stopped improving, which suggests we could see a peak in Eurozone GDP growth rates by January to February of next year.
Source: Bloomberg
In terms of disinflationary stimulus or inflationary tightening, we see that energy inflation provides a lead time for European stocks by several months. This is shown in the image below that plots the Euro Stoxx 50 Index (black line) along with the annual inflation of the Eurozone Energy Index (shown in red, inverted and advanced). The decline in energy prices late in 2012 and early 2013 correctly called the rally in European equities in the latter half of this year.
Source: Bloomberg
However, the rise in energy prices a few months ago suggests European equities peak this month and remain weak until February 2014. The stock market is supposed to be a leading economic indicator and given M1 money supply growth is calling for a peak in Eurozone GDP by January to February of next year, it is likely that European equities will discount the coming pause in Eurozone growth by peaking now.
Source: Bloomberg
We are already seeing potential signs of a top in European equities. Shown below is a multi-indicator of breadth and momentum for the Euro Stoxx 50 Index. The second panel shows the percentage of members that are overbought (RSI > 70) or oversold (RSI < 30). When 30-40% of stocks in the index have RSI readings above 70, an intermediate top is usually in. Furthermore, the recent reading was one of the highest in almost two years.
Source: Bloomberg
The third through fifth panels look at new highs and new lows over various time frames. As you can see, the Euro Stoxx 50 hit a higher high this month by exceeding the September peak, though breadth has not confirmed this rally as we see a negative divergence with fewer stocks participating in the rally. The overbought condition and weakening breadth we are seeing could be foreshadowing the weakness that the leading economic indicators are calling for.
Summary
The same leading economic indicators that called for a recovery in the European economy and stock market are now calling for a pause in which Eurozone GDP peaks early 2014. The stock market may discount this in advance by peaking this month. We are already seeing some red flags in terms of an overbought condition in the Euro Stoxx 50 Index that isn’t being confirmed by breadth. Those that are bullish on European equities may want to temper their enthusiasm.
