Different factors have been driving the main equity markets: For US stocks, the question is whether rising real yields will outweigh earnings growth and hold back the market further. For European and Chinese equities, the hot issues are fallout from the war in Ukraine and the effects of Covid outbreaks in China, respectively.
The market currently expects the US fed funds rate to peak at 3.3%, nearly 60bp above the so-called neutral rate and at a level seen as slowing US economic growth (and inflation).
We believe further tightening may be needed to bring inflation back towards the Federal Reserve’s 2% target. In contrast to the eurozone, US wage gains at 5%-6% per year are too high relative to the Fed’s inflation target, hence a period with rates in restrictive territory is needed to curtail the wage pressures. Fed chair Jerome Powell recently emphasised this point.
In Europe, the UK and even Austrialia, central banks are now tilting more towards tackling inflation pressures than supporting growth.
Admittedly, so far, company results have been encouraging. Earnings growth — excluding energy (which will post unusually high growth rates) and financials (which had been expected to show negative year-on-year comparisons) — is running at 17%, with results beating analyst expectations.
If this pattern holds, and interest rate expectations stabilise, US markets should recover, just as they did in the first quarter. That said, rising rates are typically not positive for equities. In the months ahead, we expect slowing growth, high but falling inflation (if not immediately, then soon), and financial conditions that overall are still loose, but unlikely to stay that way.
European equities – Now underweight
Historically, when interest rates rise, US small caps, growth stocks, and the energy and healthcare sectors have outperformed. That said, perhaps the most notable outperformance is that of non-US developed and emerging markets. As ECB policy, too, will ultimately move towards higher rates, investors may wish to act in anticipation of similar performance in Europe.
European equities are still benefiting from an accommodative monetary policy, but there are few other arguments in their favour. In fact, we recently moved to an underweight.
Perhaps surprisingly, earnings estimates have risen for the MSCI Europe index since Russia’s invasion of Ukraine. Higher earnings look unlikely to us even factoring in the impact of higher commodity prices. Our strategy team, for example, points to forward European equity multiples appearing rich relative to history once the right ‘E’ is plugged into ratios.
Other sectors have seen negative earnings revisions. Exclude commodities and the earnings growth rate drops (see Exhibit 1).
Not yet at buying levels
From the lows in early March, we have seen only a partial rebound. This means that equity valuations more broadly have not (yet) fallen to levels justifying a full recovery and still need to incorporate the likely downside to company earnings and cash flows.
To date, what has happened in the Russia/Ukraine conflict is reflected in market pricing. Looking ahead, we see a greater likelihood that the situation will remain challenging in the near term. This spells further downside pressure on growth and scope for higher inflation, also from the issues with supply chains related to the lockdowns in China.
Finally, part of an apparent valuation discount at the index level is – again – driven by commodities. Exclude commodities and the discount is closer to zero.
In sum, we would deepen our short position in European equities should markets rally. We are more constructive on Japanese and emerging market equities.
Short in Japanese government bonds
Moves in Japanese government bond yields have been remarkably contained as the Bank of Japan’s yield curve control policy caps the yield at just 0.25%. Inflation expectations, however, have risen by almost as much in Japan as they have in the US (see Exhibit 2) and we expect the BoJ to take action, also in view of the depreciation of the yen.
So, our short to JGBs seeks to capture a Bank of Japan move as it catches up with other developed market central banks in tackling inflation and a weaker currency. It seems unlikely to us that 10-year JGB yields would move much lower from here.
Asset class views
These are highlights from our asset allocation monthly for May. Download the pdf