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Are the markets ready for interest rates rises?
The markets are revaluing across sectors and asset classes to better align with the structural shift from low nominal growth and low interest rates to a new environment of higher nominal growth and interest rates. In addition to this secular shift, which is evident, for example, in the new commodities super cycle, the markets are undergoing a late-cycle shift to more defensive sectors that tend to outperform as real growth slows down. Stagflation will reinforce both shifts, in our view.
Q1 earnings reports to date show why Value is outperforming. While Value and Growth stocks are delivering similar revenue growth of just over 10%, Value is delivering stronger earnings per share (EPS) growth of about 8% versus 4% for Growth, according to Credit Suisse tally of Q1 earnings reported through mid-April. In the early stage of the inflation breakout last year, most companies could pass on price increases, and margins were maintained pretty much across the board.
A year later, with real incomes declining as inflation outpaced wage gains, consumers are becoming more price conscious, and more companies are having difficulty passing on higher costs, squeezing margins. Value stocks are winning, as they are better able to maintain margins. Forward-looking indicators of profits, like earnings revisions ratios (ERR) find that while overall downward revisions have begun to outnumber upward revisions, Value sectors, such as Energy, Financials and Materials, continue to see relative strength in their earnings outlook, with more upward revisions than downward revisions.
As growth slows over the next year or two, this pattern is likely to continue, in our view. In addition, rising rates are likely to continue shrinking the big relative valuation difference between Growth and Value stocks. Slower revenue and earnings growth along with higher interest rates are headwinds for Equities, especially Growth stocks.
Stocks Could Rebound, But Beware the Slowdown Ahead
In the near term, we expect the S&P 500 Index (S&P 500) to continue to recover from its March trough. Anticipation of monetary tightening, rapidly rising interest rates and the selloff in duration, the flattening yield curve, rising inflation, rising volatility and the economic stresses associated with the conflict in Ukraine have collectively driven the S&P 500 downward. Our model of the relationship between the S&P 500 and the U.S. Institute for Supply Management (ISM) Manufacturing Purchasing Managers’ Index, currently at a robust though sequentially declining level of 57.1, suggests an implied value for the equity index of approximately 4,650.
The Earnings Revisions Ratio (ERR)
The ERR is a ratio of the total number of analyst upgrades net of downgrades over the past 100 days, as a percentage of the total number of ratings. It has tended to lead the trend in aggregate earnings-per-share (EPS) estimates at the index level by a few months, and is helpful in assessing the state and direction of the regional and global earnings cycle.
The pace of net upward revisions has been declining since mid-2021 and downward revisions now exceed upward revisions. We expect S&P 500 and MSCI ACWI earnings estimates to begin getting revised downward shortly. Just as positive earnings revisions have typically signaled a strengthening profit cycle and improving sentiment for risk-taking, a negative ERR typically implies an impending slowdown in the profit cycle and an accompanying reduction in investor risk appetite.
Unsupportive Free Liquidity Growth
Free liquidity growth, which is the growth in global M2 in excess of nominal global economic growth, is now negative. A waning tide of free liquidity growth has historically presaged depressed risk appetite among investors, with sub-par MSCI AC World Index (MSCI ACWI) performance coming over the subsequent 12 months along with poor risk-adjusted returns. This reinforces our view on navigating the slowdown phase with de-risked portfolios.
What to Expect During the Slowdown Phase
History suggests some typical Slowdown phase characteristics:
- Stock market volatility rises: over the past 20 years, on average it has been 11% during Booms, but 13% during Slowdowns
- Lower-beta stocks within their respective styles have tended to outperform, as do lower-beta styles, factors and regional exposures
- S&P 500 annualized returns have averaged around zero in the Slowdown phases of the past 20 years
- Most of the largest non-recessionary market corrections have occurred in this phase
- Earnings continue to grow, although more slowly, and earnings growth expectations decline
- The stock market forward P/E multiple has tended to decline
- A Slowdown phase usually lasts 12 – 24 months
Morgan Stanley strategists say the easy returns are over for U.S. equities, credits and Treasuries, but see value in European and Japanese stocks in 2022.
Time to Lighten Up on U.S. Stocks?
In a view that is “most likely to raise eyebrows,” says Sheets, strategists think the S&P 500 index could decline 5% in 2022 while other developed markets could end the year higher. They recommend underweighting U.S. stocks to account for high valuations and more catch-up potential and less volatility elsewhere in the world.
“The persistent price outperformance of U.S. stocks for much of the last decade has been driven by superior and more durable earnings trends, but uncertainties are mounting around cost pressures, supply issues, policy uncertainty and tax changes,” says Mike Wilson, Chief U.S. Equity Strategist.
European and Japanese Stocks Are Calling
In Japan, equities continue to deliver improving returns on equity, while economic stimulus, business reopening and strong global capex all suggest that Japan’s stock market could appreciate 12% next year.
Meanwhile, the MSCI Europe index has enjoyed its best period of relative outperformance in 20 years compared to the rest of the world, and that pattern should continue thanks to increased mergers and acquisitions, buyback activity and changes in investor positioning since many global portfolios had been underexposed to the region.
“Our combined earnings and valuation assumptions suggest that European stocks can deliver an 8% price return and double-digit total return,” says Graham Secker, Chief European Equity strategist. The team’s top sector picks include autos, energy and financials, which should all benefit from the move up in real yields.
My conclusions and considerations
The markets are already discounting many interest rates rise and what we’ve seen in this article is how other markets like European and Japan could have value than US market.
Stagflation is between us and central banks are preparing for challenges years ahead.
- The markets are revaluing across sectors and asset classes to better align with the structural shift from low nominal growth and low interest rates to a new environment of higher nominal growth and interest rates.
- With real incomes declining as inflation outpaced wage gains, consumers are becoming more price conscious, and more companies are having difficulty passing on higher costs, squeezing margins.
- S&P 500 and MSCI ACWI earnings estimates to begin getting revised downward shortly.
- MSCI Europe index has enjoyed its best period of relative outperformance in 20 years compared to the rest of the world, and that pattern should continue thanks to increased mergers and acquisitions & buyback activity.
Join the conversation with your own take on these topics in the comments below.
About the Author
Alessandro is a Financial Markets enthusiastic and he loves learning from articles/papers on many financial topics and in doing so he shares with you the most interesting charts and comments.
This material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. This material has been prepared for informational purposes only. Any forecasts contained herein are for illustrative purposes only and are not to be relied upon as advice or interpreted as a recommendation.