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Investing.com - Areas of "over-optimism" in a recent rally in European equities are likely to fade, according to analysts at Morgan Stanley (NYSE:MS).
European stocks have risen so far this year, with the pan-regional Stoxx 600 index outpacing the benchmark S&P 500. The relatively cheaper valuations of European stocks versus their American peers have boosted their appeal to bargain-hungry investors, while defense sector names have surged as more European countries ramp up military spending amid concerns that the U.S. may no longer be willing to provide a security backstop for the continent.
But in a note to clients on Tuesday, the analysts led by Marina Zavolock argued that risks to stocks in the region are skewed to the downside, with cyclical names in particular tipped to underperform defensive equities. Cyclical stocks typically are more volatile due to changes in macroeconomic conditions, while defensive stocks tend to remain relatively unimpacted by fluctuations in the broader operating landscape.
They added that such a trend in Europe would mirror a rotation into defensive stocks happening in the U.S., which has seen a recent uptick in worries around the health of the broader economy due largely to President Donald Trump’s tariff plans.
European cyclical sectors, such as luxury, software and semiconductors have underperformed recently, the analysts noted.
Meanwhile, the period of relative strength in European stocks compared to their U.S. peers may be facing a "moment of truth," the analysts argued. They cited indications that the discount for holding European equities versus U.S. stocks is shrinking, as well as historical data which showed that European outperformance against the U.S. is "rarely sustained" at its current levels during previous sell-offs on Wall Street.
U.S. stocks sank on Monday, pulled down by fears that President Trump’s rapidly-shifting tariff plans could refuel inflationary pressures and weigh on growth in the world’s largest economy.