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In the wake of recent market volatility and steep share price falls, Morgan Stanley cautioned that the European banking sector is “not as attractive as it was.” On Friday, Deutsche Bank shares fell as concerns about the stability of European banks persisted after the forced acquisition of embattled Credit Suisse by its rival UBS . The German lender’s shares retreated for a third consecutive day and have now lost more than a fifth of their value this month. Morgan Stanley strategists cautioned that although the banking sector is now cheaper, news flow surrounding earnings upgrades and cash return expectations may fade or reverse. They also suggest that the cyclical window for European banks had closed — and investors should reduce exposure to the sector. “While we don’t know yet exactly how things will play out for financials from here, we are confident that the economic outlook has deteriorated and that the window for ongoing good/improving macro data is beginning to close,” said Morgan Stanley’s strategists led by Graham Secker. “We are reluctant to downgrade the sector just here as we see scope for volatility to emerge on the upside as well as the downside … however, we see further uncertainty ahead and would look to reduce exposure into any material rally,” the team added, also telling clients that “banks will be volatile up and down – we would sell into rallies.” The report highlights that every rate hiking cycle over the past 70 years has ended in a recession or a financial crisis, with the current turmoil proving no exception. Although financial crises do not always lead to recessions, the odds are unfavorable given recent events, such as tightening credit availability and a deeply inverted yield curve, according to the strategists. The gap between the 2-year and 10-year yields reached 110 basis points on the day before the Silicon Valley Bank meltdown but now stands at just 34 basis points. According to Morgan Stanley, this steepening after the failure of SVB Financial , Silvergate and Signature Bank in the U.S. and forced takeover of Credit Suisse signals an impending slowdown. On a top-down basis, Morgan Stanley recommended the following overweight-rated (a buy equivalent rating) stocks to navigate this environment with a defensive exposure. Stocks in traditionally defensive sectors, such as health care and utilities, are being recommended by Morgan Stanley. They are Swisscom , KPN , Novo Nordisk , Ahold , and SSE , among others. Citi bank has also downgraded the European banking sector . Strategists at the Wall Street bank said investors should focus on technology as the market faces increased tail risks due to concerns about the flow of credit at the major lenders. The banking concerns have also impacted the case for European equities outperforming their U.S. counterparts. Previously, European equities were expected to outperform due to a potential U.S. economic slowdown or a Fed-induced sell-off in the S & P 500. However, Morgan Stanley said the banking sector’s problems have shifted this perspective, as the outperformance of European banks has been closely tied to the broader European market. — CNBC’s Michael Bloom contributed reporting
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