- Rising bond yields should not faze equities: as long as rising bond yields are accompanied by strong nominal growth, the strong growth driver usually wins out and equities gain.
- Bond yields will be capped: in any case, the Federal Reserve will not stand by and allow 10-year yields to rise too far, given the increasing refinancing difficulties for the US Treasury. In addition, higher US bond yields will attract foreign investors back to Treasury bonds.
- Rising inflation expectations favour Small-Caps, Cyclical Value: mid-/small-cap exposure continues to outperform, benefiting from strong PMIs, growth upgrades and profit margin gains on the back of higher prices.
- Upgrading Banks, downgrading Utilities: the steeper yield curve and the prospect of the return of dividends boost Banks, while Utilities suffer from their high bond sensitivity.
- Favour commodity-related sectors to benefit from a new commodities super-cycle. Focus on global diversified mining stocks in the STOXX Europe Basic Resources, US Basic Materials sectors and mining equipment (Industrial Goods).
- We remain positive on equities as an asset class, but remain watchful for rising risks of a correction.
Global Equities view
Low but rising inflation is positive for equities
Don’t fear rising bond yields: US Treasury yields have risen over the past month from 1.0% to 1.4% at the time of writing, driven largely by rising inflation expectations.
While this may be an issue for ultra-long duration equities such as growth stocks, rising inflation expectations are generally positive for equities, if accompanied by rising nominal growth. This is clearly the case today.
As the chart opposite shows, historically rising US inflation rates are not a hindrance to equity markets, while the inflation rate remains in the 1.5% - 4% range – in fact, the best returns from the S&P 500 index have come when inflation is in the 1.5% - 2.5% range.
This comforts our preference for cyclical exposure, as cyclical stocks stand to benefit most from higher prices.
Emerging Markets, Europe at multiyear highs
World ex US looks strong: while US growth equities have been the standout performers of the last couple of years, we should note that the MSCI Emerging Markets and STOXX Europe indices have both recently reached new all-time highs. This is a very strong positive momentum signal, and suggests the potential for these stock markets to recover some of the ground lost to the US over the past few years.
Earnings momentum is positive for both regions, while the more cyclical bias of EM and Europe versus the US stands them in good stead at a time when global producer prices are rising quickly.
Emerging Markets and European stock markets have recently broken out to new all-time highs, driven largely by the more cyclical elements of these stock markets. The preliminary success of COVID vaccines in cutting new infection rates and hospitalisations suggest that consumers will boost these regions over the rest of 2021.
Low albeit rising inflation rates have historically been an excellent regime for equity markets, when nominal economic growth is also accelerating. With plenty of slack still evident in the global economy post the COVID-related lockdowns, we see scope for global equities to surprise further to the upside in earnings terms in the months ahead.
Q4 earnings season in focus
Excellent and improving earnings in the US!
Even if there were some positive ‘exceptionals’, especially among banks (such as a decrease in provisioning), earnings surprises are well above the 5-year average of 6.3: with now the vast majority of US companies having reported, the S&P 500 index has beaten earnings expectations by +17%!
Upward earnings revisions have been massive in all sectors. At aggregate level, only the US industrials sector looks weak but it is due to the large exceptional loss of one big company.
Energy, banks and tech hardware have recorded the strongest 2021 EPS upgrades in the US during the reporting season (source: Exane). Defensive sectors have the smallest earnings revisions.
More companies are now providing an outlook for 2021 whereas recently, many did not dare to be too precise. Earnings expectations are continuously being revised upward.
Encouraging earnings results in Europe
Similar to the US, financial companies have so far reported quite stronger profits than expected. In general, cyclical companies’ results and earnings revisions are very encouraging.
Exane and other prominent investment houses believe that upward earnings revisions/recovery are going to continue in cyclical sectors. The momentum is expected to last longer.
On the contrary, defensive and growth sectors are currently facing some downward earnings revisions.
Our new global sector allocation (see further below) is incorporating this good news on the economy and on cyclical sectors in particular.
MSCI Europe 2021 EPS is now expected to come back to -4% against 2019 EPS. In 2022, MSCI Europe EPS should be 11% higher than in 2019 (see more figures/ IBES forecast in the Appendix).
The Q4 earnings season was excellent in the US: more than 80% of companies beat their forecasts (it is quite above the 74% average), on average by +17%. Q4-20 EPS are slightly positive on a y/y basis, a great achievement in the pandemic context! US EPS are now expected to grow +22.6% y/y in 2021 after falling -13% in 2020. In Europe, earnings surprises have been around +10% on average. Earnings still drop -14.4% y/y.
Theme/Sector in Focus
Complicated environment for Banks in 2020
At the beginning of 2020, the COVID-19 health crisis halted the economic acceleration of the 2017-2019s. The context then had become very favourable for banks - especially American - helped by a degree of deregulation and tax cuts under the Trump administration.
Apart from the supporting factors mentioned above, the banking and financial sectors tend to outperform in the context of economic recovery, leading to a rise in inflation and a steepening of the yield curve.
In 2020, thanks to huge monetary and fiscal support everywhere around the world, the recession was far smaller than feared. But banks have often had to cancel their dividends. The recovery remained uncertain pending mass production of COVID vaccines as new, even more virulent strains emerged. But vaccines seem effective and vaccination is going well.
Our preference at the end of 2020 was for the insurance sector thanks to better visibility of profits, with balance sheets looking less risky and dividend payments more certain.
Banks are now back!
The last earnings season proved very good for banks. They now allow write-backs from provisions. This has resulted in exceptional profits and upward revisions to earnings expectations. In addition, they are once again authorised to pay dividends thanks to balance sheets deemed solid enough.
Yield curves have steepened: 10-year Treasury yields rose from 1% to nearly 1.6% in the space of a few weeks; and the German 10-year Bund from -0.55% to -0.3% while short-term rates are still at a floor. They are still set to remain there for about two years, according to expectations.
The global economic recovery looks much more solid and sustainable now and we are therefore upgrading the banking and financial sectors in general to positive as they are lagging behind the cyclical rally and, above all, they are still cheap in relative and absolute terms.
The global economic recovery looks much more solid and sustainable now and we upgrade the banking and financial sectors in general to positive as they lag behind the cyclical rally and, above all, they are still cheap in relative and absolute terms.
Other thematic preferences
UK mid-caps attractive in post-Brexit world
UK roadmap out of lockdown announced: Prime Minister Boris Johnson announced on 22 February his plan for the UK to gradually exit their current lockdown, judged by Oxford University to be one of the strictest in the world at present.
Two clear positive drivers for the UK economy exist: firstly, the Brexit deal that was agreed between the European Union and the UK reduced the “cliff-edge” risk of a no-deal Brexit for the UK economy. Yes there is a negative impact on UK growth from exiting the EU, but far from the chaos of a no-deal exit.
Secondly, the potential for a sharp recovery in UK consumption following a successful COVID vaccination programme should drive domestic stocks. Hence our clear preference for exposure UK equities via the FTSE 250 mid-cap index.
Continued leadership from Small/Mid-Caps
Small is still beautiful: we have continued to see a sharp rotation out of momentum into small-caps and the value style over the last 3 months, on the back of the sharp equity market advance.
In February, small size was still the dominant factor, while in the US, momentum rallied to remain in second place in the factor race (from November last year).
Overall though, higher bond yields and the resurgence in inflation expectations over the last few months, together with a very strong global manufacturing PMI all support outperformance of cyclical value over longer-duration growth.
The success of the UK’s vaccination programme should allow for the progressive re-opening of the UK domestic economy, boosting consumption and thus re-opening plays in the Travel & Leisure, Retail and Autos sectors. With consensus growth forecast at 5% on average in 2021e and 2022e, the UK FTSE 250 mid-cap index should benefit most.
The Context is Favourable for Cyclicals
Materials, industrials energy and financials have continued to rise globally and remain well oriented. Defensive sectors such as Utilities and Consumer Staples under-performed in February.
European REITs have also performed poorly. The sector had performed well late 2020 but some doubts remain about the future market share and profitability of the traditional shopping malls and office market. We consider REITs are too cheap and an attractive diversification.
In February, growth sectors such as technology and healthcare have started a correction due to rising bond yields and inflation fears. Conversely, industries that should profit from the end of the lockdowns (travelling, leisure, energy, etc.) have been performing better.
Upgrade Banks, Downgrade Defensives
Cyclicals results have been very good and earnings revisions are still often up there, including now for Banks. Therefore, we remain confident cyclicals will keep outperforming in the near future.
Bank results have been reassuring and they are going to start paying dividends again. They are still relatively cheap and lagging in the recovery. Therefore, we upgrade Banks and Financials to +.
Conversely, after its great performance recently, European tech needs a pause and we downgrade it from + to =.
We avoid consumer staples (expensive and too defensive) and now also utilities (from = to -) for similar reasons. Pharma and health care are also downgraded from + to = as too defensive.
As the reflation could be stronger than expected, inflation fears are coming back as well as rising bond yields. Cyclicals are not that expensive yet whereas growth sectors look more vulnerable due to their higher valuation and good performances in 2020. We therefore decrease this month Pharma and Health Care from + to = as well as European Tech (from + to =). Utilities are downgraded from = to -. Conversely, Banks are upgraded from = to +.