Equities Outlook: DM Down Then Recovering
- U.S. Equities can fall into mid-year, as the market is still overvalued even after the March decline in bond yields after playing for economic recovery and Fed rate cuts too early. This has been complicated by March’s banking sector turbulence in the U.S. and Switzerland. On balance, we do not see a systemic banking crisis (here), but rather an enhanced credit squeeze that hurts activity and ends the DM tightening before some central banks desire. Additionally, an equity market selloff is required to push the Republicans to seal a deal on the debt ceiling in the middle of the year. Scope exists on the S&P500 to fall to 3800 and potentially 3500.2024 recovery hopes can then kick in during H2 and we still see a rebound to 4200. We maintain the forecast of 4700 for end 2024.
- Elsewhere in DM, EZ equities are no longer cheap, but aggressive ECB tightening has still to have its full impact on the economy and earnings. EZ equities will struggle to match the U.S. in H2 2023, but 2024 should be better. However, we do not see a credible peace deal for the Ukraine war, as the sides are too far apart.
- In EM, we still see scope for China equities to outperform the U.S. by 10% by end 2023, both as the authorities take measures to reinforce the rebound after the ending of zero COVID policies and as valuations are still cheap. India overvaluation will still see it lagging in H1, but good corporate earnings growth points to 10% upside in H2. Finally, Brazil has 10-15% upside for the remainder of the year, which is less than our December forecast as most BCB easing is delayed until 2024.
- Risks to our views: Fed tightening to 6% plus would likely prompt a U.S. recession and delay the rebound in the U.S. and global equity markets into 2024. A modest risk scenario is that China supplies weapons to Russia and the U.S./West impose major sanctions on China that triggers fears of a global recession and a hit to equities.
Figure 1: S&P500 12mth Fwd P/E Ratio and 10yr Real Government Bond Yield (inverted)
Source: Continuum Economics projections until end-2023 using 10yr U.S. breakeven inflation and Treasury yield forecasts
U.S. Equities: Overvaluation and Debt Ceiling more than Earnings
Our forecast for 2023 U.S. growth is now less pessimistic than December, as the fallout from the regional bank crisis on financial conditions only partially counterbalances better economic momentum seen over the winter. Even so, we still see a mid-year slowdown, which will be a borderline recession, and this will produce a further downgrade of 2023 earnings expectations. However, the gap between consensus (zero) and our forecast (-2%) for the S&P500 is now small and we are more concerned about valuations and the debt ceiling.
Market hopes that the Fed was peaking and less fear of a recession drove a rise in the forward P/E ratio in January/February (Figure 1). Then, in March, the decline in government bond yields has offset the banking problems from a sentiment standpoint. The problem is that Fed Funds and 10yr nominal and real yields are unlikely to move lower in the remainder of2023 and easing will likely be in 2024 and 75bps (here). If anything, 10yr yields will likely remain elevated with the traditional yield curve steepening from the bottom of the slowdown. Additionally, if the U.S. economy does show mid-year weakness then this will likely sour equity market sentiment. Meanwhile, the debt ceiling resolution needs a drama in the equity market before a last minute solution is found and this increases downside market risks into mid-year.
This all means a move down to 3800 and potentially 3500 for the S&P500, if the economic slowdown coincides with a debt ceiling crisis. However, we maintain the view of a rebound to 4200 by end 2023, as the debt ceiling is resolved/focus switches to 2024 economic recovery, Fed tightening ends and the focus turns to 2024 easing hopes. For 2024, we maintain the forecast of 4700, with economic recovery producing a 12% increase in earnings and most of that feeding into market prices rather than decreases in earnings multiples.
Figure 2: Germany/UK 12mth Earnings Yield minus 10yr Real Government Bond Yield (using 10yr breakeven inflation)
Source: Datastream, Continuum Economics
Europe will likely be able to muddle through late 2023 and late 2024 with current gas supplies, before large new gas supplies in U.S/Qatar in 2025 help to produce a structural decline in gas prices. The range for EZ gas prices (TTF) will likely be EUR35-75 in 2023, which is lower than 2022 and means that the squeeze on the economy and boost to inflation will be reduced. This has prompted us to temper our 2023 recession forecasts but also lower our inflation projections.
However, EZ equities are no longer undervalued on a forward P/E ratio basis or against 10yr real bond yields with breakeven inflation rates. Our long-term measures (with our 2023 projections & unchanged markets) also show Equity-Bond yields (Figure 2) coming back into line with the average due to real yields rising with breakeven inflation rates remaining close to current levels. Meanwhile, the main scenarios are that the Ukraine war drags on into 2024 or a stalemate occurs that at best leads to a ceasefire but not a major peace deal (here). Only a credible peace deal that includes a reduction in Russian sanctions would drive EZ outperformance versus the U.S. in 2023 and this is unlikely. It is instead more likely that EZ equities for the remainder of the year match U.S. equities or see a small underperformance – we feel the ECB is making a policy mistake and this will temper the recovery in 2024 (here). The rebound of the Euro is also a headwind for EZ equities.
UK equities have had a choppy start to 2023, as concerns over the UK/EZ recessions have been tempered with the sharp decline in wholesale gas prices. However, we still see a recession and slow recovery, as the BOE tightening of financial conditions has yet to fully feed through. But UK equities are discounting a lot of bad news and can outperform U.S. and EZ equities by 5% in the remainder of 2023. Hopes of a recovery and some BOE rate cuts in 2024 can drive a further 10% rise in 2024.
Japanese equities have lagged DM markets, both due to BOJ policy uncertainty and the bounce in the JPY tempering exporter optimism. We see a further 25bps increase in the BOJ 10yr yield cap under Ueda coming September/October, while also forecasting a further JPY appreciation to 120 v USD by end 2023. This is a difficult environment for Japanese equities and they will likely lag U.S. equities slightly in 2023 and more noticeably in 2024 – PM Kishida reforms are insufficient to significantly boost return on equity.
Emerging Markets
China’s equity market has bounced this year, but does not discount the scale of the boost to GDP and earnings growth in 2023 from the shift to an endemic COVID policy. Policy in 2023 will also support growth and equity market optimism, with further measures to boost cyclical growth likely to be announced after March’s RRR 25bps cut. Additionally, though the equity market is no longer as cheap as Q4 2022, we still view it as undervalued on equity only measures – especially as previous market recoveries have tended to push the 12mth forward P/E ratio to 15. China’s equity market also benefits from still favorable comparisons versus nominal and real government bond yields (Figure 3). Though we see the PBOC lifting the 7 day policy rate by 10bps in late 2023 and 30bps in 2024, this is slow and 10yr government bond yields will likely only reach 3.15% by end 2023. In January we upgraded the 2023 outlook for Chinese equities to a 10% outperformance versus the U.S. during the remainder of 2023 and we stick with that view. Chinese equities should also do well in H1 2024, before the story switches to fiscal policy consolidation and the long-term slowing of structural growth (here).
Figure 3: China Earning-Bond Yield Relative (%)
Source: Continuum Economics. CAPE Earnings Yield-10yr Real government bond yield
Figure 4: India 12mth Fwd Earnings Yield minus 10yr Government Bond Yield (%)
Source: Datastream/Continuum Economics
India has underperformed other EM equity markets so far in 2023, both on overvaluation and as EM portfolios shift back into China. The overvaluation is easing with healthy 2023 corporate earnings growth, but still exists versus the 12mth forward P/E ratio average over the last 5 years and against 10yr government bond yields (Figure 4). H1 can see this valuation drag remaining, but as RBI rates peak and expectations grow that inflation will rotate back down towards target then the focus will likely shift to long-term earnings optimism. A 10% rally can be seen before end 2023 and thus small outperformance of the U.S.2024 should be better helped by corporate earnings momentum and also the reelection of reform minded Modi – we see scope for a 15% rally in 2024.
Finally, we have revised down the projection for Brazilian equities in 2023 to a 10-15% rally for the remainder of the year, as the BCB will cut less than we projected in December given core inflation and inflation expectations. However, fears over major fiscal easing by Lula’s government are overdone, as shown in Haddad fuel tax changes recently (here) and we see only modest fiscal plans. Additionally, the government now supports the BCB inflation targets and fears that it would be increase/undermine central bank credibility have been dismissed. With rate cuts in 2024 and a recovery in the global demand for commodities, we see scope for a further 15-20% rally in Brazilian equities in 2024.