Equities Outlook: Tactically Difficult/Strategically Bullish

• The next few months will be tricky for global equity markets, as the feedthrough of aggressive DM central bank tightening becomes clearer for the economy. This means greater downside risks around a central scenario of stagnant 2023 corporate earnings in large DM’s. The U.S. equity market is modestly overvalued and we see a move down to 4000 for the S&P500 before 4200 end 2023. Other DM and EM equity markets will take direction from the U.S. in the coming months, which suggests a dip before a recovery.
• 2024 should be a good year helped by a H2 global economic recovery and Fed/ECB rate cuts. We see 4700 still for S&P500 by end 2024.
• EZ Equities can outperform the U.S. by 3-4% by end 2024, helped both by still reasonable valuations relative to government bonds and the prospect of a 2025 improvement in gas energy security with the major new imports from Qatar and U.S.  Japan and UK equities can outperform the U.S. by 5% over the same period. Fears over UK core inflation and BOE rate hike prospects are overdone and cheap valuations will help. Japan can be helped by the BOJ retaining QE with yield curve control with one final adjustment of the 10yr JGB yield cap to 0.75%.
• Most EM equities (ex India) have favorable valuations and can benefit from H2 2024 global economic recovery/rate cuts as inflation comes back to target quicker than DM, helped also by the downtrend of the USD versus DM currencies spilling over into EM. EM Asia ex China and Brazil are attractive on an 18 month view. Chinese cyclical pessimism is overdone and outperformance could be seen in H2 2023 as U.S./China relations improve with multiple meetings between President Biden and Xi and as more policy easing is delivered. However, structural headwinds will likely see China lagging EM Asia ex China in 2024.
• Risks to our views: DM tightening could be more powerful than the baseline and trigger a modest U.S. recession and more prolonged EZ/UK recessions. This could hurt corporate earnings forecasts and risk sentiment and produce a moderate hit to equity markets.

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. Market consensus is Bloomberg poll of 10yr nominal yields and current 10yr breakeven inflation.

U.S. Equities: Structurally Bullish but Slowdown First 

The U.S. equity market has proved resilient in 2023 so far, which is raising the question about whether the market can ignore a H2 economic slowdown and just focus on 2024 Fed rate cuts and a return towards normal growth and inflation in the coming years. The answer to this idea is partially dependent on the scale of an economic slowdown, which we now see as a period of slow to modest growth in H2 2023 rather than our previous borderline recession forecast. A mild recession would probably not derail corporate earnings expectations too much, as a number of key sectors have already gone through an adjustment phase in 2022 and 2023 (e.g. Tech and communications). A moderate recession would be a game changer for the near-term corporate earnings outlook, but we see this as being low probability. The current S&P500 earnings expectations of +1% and +12% for 2023 and 2024 are helpful, especially after the summer when the market will be focusing on the 2024 outlook more.

Our key concern remains valuations in equity only terms and against bonds. The 12mth forward P/E ratio is modestly rich relative to its own history and at this stage of the economic cycle (Figure 1). Additionally, the sharp adjustment in nominal and real government bond yields in the last 2 years does produce a valuation shift relative to fixed income. Our 10yr yield forecast is for elevated yields through the next 18 months which produce modestly positive real yields (using 10yr breakeven inflation projections) that would normally be consistent with a lower 12mth forward P/E ratio for the S&P500. Market expectations are for 10yr real yields to fall to +1% into 2024, which is more optimistic than our view (we see 2020’s supply problems, QT and inflation uncertainty meaning higher 10yr real yields). The optimism that the U.S. has avoided a hard landing, plus perceived U.S. equity market exceptionalism in Tech and AI, can warrant a higher 12mth forward P/E than suggested by this model. The 12mth forward P/E ratio is also within one standard deviation of the 10yr average, while some are also looking at 2yr forward P/E ratio. But the current degree of overvaluation suggests a fair amount of good news is discounted and even a phase of stagnant growth in the U.S. economy could be enough to produce a tactical retreat. We still look for the S&P500 to dip to 4000 before an end year recovery to 4200.

2024 is likely to be a different story as the cyclical headwinds ease and the Fed actually starts an easing cycle, while the GDP momentum slowly gathers steam into H2 2024 and the core PCE inflation trajectory comes closer to the Fed target. This is almost a goldilocks situation for U.S. equities and the rally in equities will likely broaden. We see scope for most of the prospective rise in corporate earnings to filter into a rise in equity indexes and we forecast 4700 by the end of 2024.

Figure 2: Germany/UK 12mth Earnings Yield minus 10yr Real Government Bond Yield (using 10yr breakeven inflation)

Source: Datastream, Continuum Economics

In terms of other DM equity markets, we project that the EZ equity market will likely show a similar trajectory to the U.S. equity market near-term, but may outperform by 3-4% by end 2024. EZ GDP figures mask the damage seen to domestic demand and the lagged feedthrough of ECB tightening is now feeding through to mean a more prolonged shallow recession and very slow growth in 2024. ECB caution on inflation will also likely not switch to aggressive easing in 2024. Meanwhile, although the Ukraine war is moving towards a stalemate, we would see the prospect of a credible peace deal and lifting of Russian sanctions as being low probability (here). However, EZ equity valuations are lower than the U.S., while EZ equities are still cheap compared to real bond yields (using breakeven inflation Figure 2). This will likely be more powerful in helping European equities. 

The UK equity market is cheap versus 12mth forward P/E ratio history. Meanwhile, though the rise in 10yr gilt yields since the start of 2021 has been greater than the U.S./EZ, equity-bond valuations are still favorable to UK equities compared to the U.S. (Figure 2). We do see the UK outperforming the U.S. by 5% by end 2024, as this valuation discount unwinds but the growth/core inflation picture will likely be a headwind to further outperformance. One swing factor is the timing of the UK general election, which could happen in H2 2024 given the deadline of January 2025. If it does happen early then Labour are likely to have a majority and their objectives of green growth and a closer relationship with the EU could help UK equities outperform more.

Finally, Japanese equities have had a stellar 3 months on inflation, company buybacks and switching from low yielding deposits/fear of growing negative real yields. This momentum can carry on in H2 and we see scope to outperform the U.S. by a further 5-10% in the remainder of 2023. However, then Japanese equities would be towards the top of the 12mth forward P/E ratio band seen since 2010 excluding 2020/21 (during the ultra QE phase in the COVID crisis). Meanwhile, the BOJ is trying to scale down the ongoing size of QE with YCC and we see a 25bps increase in the 10yr JGB cap in September/October, though not abandoning QE with YCC, which would be an adverse shock if it occurred. Additionally, inflation should slow more than expected into 2024, reducing the scale of negative real yields. Thus for 2024, we see around 5% upside for Japanese equities compared to 7% for the S&P500, though over the 18 months Japanese equities should still outperform.

Emerging Markets 

Major emerging equity markets have attractive 12mth forward P/E ratios relative to the U.S., with the exception of India, and we are forecasting a multi-year decline of the USD versus key DM currencies. Meanwhile, our growth forecasts across major EM are better than DM and most major EM central banks will be able to bring inflation towards target into 2024.This is a constructive macro and policy picture for EM equities. However, two issues exist for EM equities. 

Firstly, equity-bond yield measures are not as compelling across all major EM equity markets (Figure 3). High 10yr real yields in Brazil and S Africa counter cheap equity only valuations. India’s lower real yields are different but structural overvaluation of the Indian equity market on a 12mth P/E ratio basis depresses the earnings yield. China is cheap on the equity-bond yield measure, due to low equity valuations.

The 2^nd issue is geopolitical. Russia remains uninvestable for global fund managers without a credible peace deal. However, the valuation destruction of Russian assets is also a reminder of portfolio risks to Chinese assets if China were to invade Taiwan or have U.S. sanctions imposed for any arms sales to Russia. This is leaving global portfolio managers with divergent views over whether China is cheap and will rerate earnings multiples or whether the 12mth forward P/E ratio needs to remain below average to take account of China’s geopolitical risks.

Figure 3: China Earning-Bond Yield Relative Cheap Compared to Other Big EM’s (%)

Source: Continuum Economics. CAPE Earnings Yield-10yr Real government bond yield 

We maintain the view that China related geopolitical fears will ebb in H2, both as China’s authorities provide moderate additional stimulus to broaden the economic recovery and as President Biden and Xi endeavor to show a better relationship at the September G20 summit and November APEC Summit in San Francisco. China does not have the military strength to successfully invade Taiwan (here), though some China inspired political misinformation and tensions will likely be seen in the Taiwan election in January 2024 just like 2020. China will also want to avoid sanctions relating to its support for Russia. The downgrade of 2023 economic forecast has now largely been completed and enough economic momentum exists for us to forecast 5.5% GDP growth and double digit corporate earnings growth. We see scope for a 10% rally in China equities in H2 2023.2024 can also see a further 5% rise, with China underperforming other major DM and EM equity markets in 2024. The gains will likely fade in 2024, as financial markets look towards a trend down to 3% growth by 2026-28 (peak labor force, debt and property hangover) that will likely drag long-term corporate earnings growth down. China equities are a cyclical story, rather than a structural story and we still prefer India or EM Asia ex China on a 1-5yr view in EM Asia.

Indian equity market overvaluation reflects expectations of the best long-term corporate earnings prospects across major global equity markets, while China bears also favor India within EM Asia or EM equity baskets. The valuation issue means that corporate earnings growth in 2023 and 2024 will likely not feed fully into the equity index, but rather a rally and some de-rating of the P/E multiple. The remainder of 2023 can see a further 5% rally, partially as some also become nervous that the 2024 election could be close and cause fiscal and structural policy uncertainties.2024 should be better with a 15% rally by end 2024. The RBI will likely be cutting interest rate in H2 2024, while the election should see a return of a Modi led coalition that will look to more structural reforms.

Figure 4: Brazil 12mth Fwd Earnings Yield and 10yr Government Bond Yield (%) 

Source: Datastream/Continuum Economics 

Finally, the Brazilian equity market has started to outperform in recent months on the decline in 10yr government bond yields. This has further to go as Brazil will likely start a multi-year easing cycle in the autumn and a structural decline in 10yr yields has normally been accompanied by bull markets in equities (Figure 4). While the BCB will not be aggressive, 2024 easing will be anticipated in 10yr bond yields and they can fall further and allow a rerating of the 12mth forward P/E ratio throughout H2 2023 and 2024 (like 2003-04 and 2009).Fears have also been too great on government fiscal credibility. We see scope for a further 5-10% rally in Brazilian equities in H2 2023 and then a further 10-15% in 2024, as the BCB cuts the policy rate to 8.5% by end 2024.