Solid macro momentum supports equities

October 30, 2020 09:39
Photo: Reuters

We expect equities to move higher over the coming months, as solid macro momentum is set to support earnings upgrades. We continue to prefer emerging markets and US equities, but acknowledge the upside potential for Eurozone equities as value stocks (mostly financials) may receive a boost from slightly rising nominal rates. We have a preference for cyclical sectors in general and are cautious about defensive sectors. This is also reflected in our prudent stance on Swiss equities, whereas UK stocks may further be weighed down by appreciation of the sterling resulting from a Brexit deal.

The consolidation in equity markets in September has put a sudden end to the strong rebound after the COVID-driven sell-off in March. Although the low-hanging fruits may now be picked, with valuations breaching previous peaks, we think further upside is likely. The economic recovery remains intact, supporting the positive momentum in earnings.

The rally between mid-March and the end of August has primarily been driven by a sharp re-rating in equities. The US P/E on 12-month forward EPS has been re-rated by 80% to a 20-year high of 23.5x. This may seem extreme at first, but is primarily a consequence of the sharp drop in US real rates, which have contracted by 160 bps in response to easing by the Fed. As their monetary policy is set to stay accommodative, central banks will provide a floor for securing valuations.

With valuations anchored, further upside will have to come from better earnings, where, in general, expectations have followed the upturn in macro momentum. Revisions are positive in the US and have troughed in Europe. The current environment should support cyclical sectors and provide an increasingly positive backdrop for value stocks. If nominal rates continue to rise (we see 25 bps upside for 10-year US yields by mid-2021), value will likely re-rate further versus growth stocks. Regionally, we continue to see the most upside in emerging markets, tactically and strategically, and remain positive about US equities. A clear-cut election outcome should limit uncertainty in Q4 and raises the probability of a fiscal package, which is required to reduce risks for the US economy. We are increasingly optimistic about the Eurozone, while nations with defensive regional exposure, such as Switzerland, face headwinds in an environment of rising nominal yields. UK stocks may be attractively valued, but face downside pressure if a Brexit deal triggers a surge in the sterling.

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Equity Strategist at Bank J Safra Sarasin