European stockmarkets: enjoy the rally while it lasts

Equities' recent rebound is highly unlikely to mark the start of a long-term bull market, as a note on pan-European stocks by Morgan Stanley points out this week. The bank's study of 19 previous major bear markets shows that long periods of 'range trading' are typical after the initial slide and rebound as "structural problems in the real economy" prevent a new sustainable bull run from getting going. It's likely to be a similar story this time.

One problem is that European governments will have to repair their lousy government finances in the next few years. Across the 15 western European EU members, the budget deficit is expected to hit 7.4% of GDP and government debt 82% of GDP in 2010. By comparison, the Stability and Growth Pact governing the eurozone limits budget deficits to 3%. A combination of tax hikes, spending cuts and more privatisations will be needed. In addition to fiscal tightening, both banks and household sectors will need to cut their debts over the next few years. These three long-term economic headwinds will hamper growth, creating a "stop-go, volatile" economic cycle and causing "range-bound markets for years to come".

While rebounding growth and earnings look set to underpin stocks for a few more months, the start of fiscal and monetary tightening will cause a correction and the start of a sideways movement of the pan-European MSCI Europe index in a large range between 600 and 1,200, reckons the bank (the index is now around 1,000). The message is clear, says Neil Hume in the FT: "enjoy the rally while it lasts".

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