European Strategy And Economic Surprises For 2010 By Morgan Stanley

The European factory of research at the gates of Morgan Stanley have produced hefty report and published it yesterday. The strategy team, including Teun Draaisma, outlines the base case for 2010:

We are bullish on growth, and bearish on the consequences of some stimulus withdrawal. We think the ongoing rally will take MSCI Europe (latest 1,091) as high as 1,200, but we expect it to end 2010 at 1,030, 5% down for the year.

Of course, the strategists are challenging the consensus, and actually consider the 3 key surprises to be more probable than markets are currently pricing in:

First, the US dollar rebounds, leading to developed equities outperforming emerging.
Second, Pharma is a surprisingly large outperformer as it cuts costs and benefits from emerging market exposure and corporate action.
Third, the UK becomes the first of the G10 to have a major fiscal crisis as elections lead to a hung parliament.

The third surprise with the UK fiscal crisis fits well into the sharp v-shaped global recovery picture? Well, strategists go on with more details:

The poor state of government finances is one of the key risks we see in the medium term. Therefore, one tail risk and potential surprise is that a government bond and FX crisis materializes already in 2010. One candidate for such a scenario, although not our base case, is the UK, where the upcoming election could provide a catalyst, particularly if it results in a hung parliament. Such an outcome would likely lead to a coalition or minority government, where the ability to govern effectively would depend on the main party’s ability to forge a consensus view to drive through necessary change. In the run-up to the election, growing fears over a hung parliament would likely weigh on both currency and gilt yields as it would represent something of a leap into the unknown and (given that the last hung parliament in the UK was in 1974). It would also increase the probability that some of the rating agencies remove the UK’s AAA status.

Weak UK macro backdrop.
Severe weakness in GBP and gilts …
… but UK equities may benefit.

It does not stop there, as European economists are not shy to list their own views:

The consensus, and our base case for 2010, is a lacklustre, sub-par cyclical recovery, subdued consumer price inflation and a hesitant removal of policy stimulus in the second half of the year. With capacity utilisation still extremely low and unemployment set to rise until the second half of 2010, domestic demand dynamics – both consumer and investment spending – should remain muted.

And the surprises by economists are:

We see four potential surprises that could affect the macro outlook:
1. a late-cycle credit crunch;
2. a new commodity price spike;
3. ample liquidity pushing bond yields down; and
4. the re-emergence of country-specific political risks in Europe.

Click on chart to enlarge, courtesy of Morgan Stanley.

Who said strategists and economists are optimists? What, if probabilities are even higher? They focus on UK, but what about Greece, Spain, Austria, Italy, Portugal, Ireland ...?