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
BNP PARIBAS ASSET MANAGEMENT UK Limited, “the investment company”, is authorised and regulated by the Financial Conduct Authority. Registered in England No: 02474627, registered office: 5 Aldermanbury Square, London, England, EC2V 7BP, United Kingdom. In Australia, the investment company is exempt from the requirement to hold an Australian financial services license under the Corporations Act 2001 in respect of the financial services. This document is distributed to wholesale clients only in Australia by BNP PARIBAS ASSET MANAGEMENT Australia Limited ABN 78 008 576 449, AFSL 223418.
This material is issued and has been prepared by the investment management company. This material is produced for information purposes only and does not constitute:
1. an offer to buy nor a solicitation to sell, nor shall it form the basis of or be relied upon in connection with any contract or commitment whatsoever or2. investment advice.
Opinions included in this material constitute the judgment of the investment management company at the time specified and may be subject to change without notice. The investment management company is not obliged to update or alter the information or opinions contained within this material. Investors should consult their own legal and tax advisors in respect of legal, accounting, domicile and tax advice prior to investing in the financial instrument(s) in order to make an independent determination of the suitability and consequences of an investment therein, if permitted. Please note that different types of investments, if contained within this material, involve varying degrees of risk and there can be no assurance that any specific investment may either be suitable, appropriate or profitable for an investor’s investment portfolio. Given the economic and market risks, there can be no assurance that the financial instrument(s) will achieve its/their investment objectives. Returns may be affected by, amongst other things, investment strategies or objectives of the financial instrument(s) and material market and economic conditions, including interest rates, market terms and general market conditions. The different strategies applied to the financial instruments may have a significant effect on the results portrayed in this material. This document is directed only at person(s) who have professional experience in matters relating to investments (“relevant persons”). Any investment or investment activity to which this document relates is available only to and will be engaged in only with Professional Clients as defined in the rules of the Financial Conduct Authority. Any person who is not a relevant person should not act or rely on this document or any of its contents. All information referred to in the present document is available on www.bnpparibas-am.com
The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay. Investing in emerging markets, or specialised or restricted sectors is likely to be subject to a higher than average volatility due to a high degree of concentration, greater uncertainty because less information is available, there is less liquidity, or due to greater sensitivity to changes in market conditions (social, political and economic conditions). Some emerging markets offer less security than the majority of international developed markets. For this reason, services for portfolio transactions, liquidation and conservation on behalf of funds invested in emerging markets may carry greater risk.