Equities Outlook: Diverging Earnings and Valuations

• For other DM equity markets, equity-only valuations are more normal and still cheap against real 10yr government bond yields (using breakeven inflation). However, the EZ will see a recession and then only a slow recovery, while Japan will see below consensus inflation in 2024 that will dent the idea that it has escaped low inflation. We see EZ and Japan merely matching the U.S., though the UK can outperform on hopes that a new Labour government will improve trade relations with the EU.
• China’s equity market is undervalued and can see intermittent rallies. However, China policymakers only want to undertake targeted rather than aggressive easing and this will restrain the market, as growth slows further in 2024 to 4%. India can outperform the U.S. helped by superior corporate earnings momentum, though our favorite market remains Brazil where we see 15-20% returns. Brazil can benefit from persistent reduction in the policy rates and an associated rise in earnings multiples.

Risks to our views: Larger than expected effects from DM monetary tightening could cause downside surprises on U.S./EZ growth and hurt the global economy and earnings outlook. Equities would see a volatile 2024, with downside and then a rebound (on more aggressive policy easing) but less overall net positive returns than our baseline view.

Figure 1: S&P500 12mth Fwd P/E Ratio and 10yr Real Government Bond Yield (inverted) (%)

 Source: Continuum Economics projections until end-2024 using 10yr U.S. breakeven inflation and Treasury yield forecasts. Baseline see 3.90% 10yr yields end 2024, alternative scenario 3.20%. 

U.S. Equities: Economic Resilience Versus Valuations 

U.S. equities earnings doldrums (Q4 22-Q2 23) are expected to be replaced by circa 12% S&P500 earnings growth in 2024, as the squeeze on profit margins eases and the economy sees a soft landing rather than a harder landing that could cause a double dip in corporate earnings. Though 2024 GDP growth will be slower than in 2023, it is this corporate earnings bounce and expectations of resilience in the coming years that helps support the bullish attitude towards the U.S. equity market. Part of the reason for the resilience in the face of a sharp rise in interest rates is that the U.S. household sector deleveraged between 2008-18 and currently enjoys a huge net wealth position. The U.S. equity market also has the benefit that mega tech companies are mainly U.S. organizations, which benefit from the IT and AI waves – though at current valuations a lot of this multi-year story is discounted. Finally, buybacks will likely be sustained at a healthy pace provided the U.S. economy avoids recession,

Valuations are the main headwind to the upside, with the 12mth forward P/E ratio elevated relative to its own history. Against current and prospective 10yr real yields using breakeven inflation, the U.S. is currently overvalued (Figure 1) and vulnerable to an earnings multiple derating on any major bad news (e.g. U.S. hard landing). It is certainly the case that our end 2024 10yr U.S. Treasury yield forecast is above consensus at 3.90%, due to QT and deficit/debt trajectory. However, even with an alternative scenario of 3.2% 10yr yields by end 2024, 10yr real yields in themselves would still argue for a lower forward P/E ratio. Using Earnings yield to Real bond yield gap (Figure 2), the U.S. equity market also looks expensive on its own history.

This is a battle that will likely be played out multiple times during 2024. We do see vulnerability at current valuations in the period when the Fed Funds remains at its peak level until spring 2024, especially if any real sector data seriously challenges the soft landing narrative. This could mean a decline to 4200 and we still keep this forecast for end 2023. From spring 2024 onwards, Fed rate cuts should reestablish the rally. Normally this would be powerful, but at current valuations we look for only moderate gains and now forecast 4800 for end 2024. Tactically politics will impact market sentiment depending on how the front runners are progressing, but our current baseline is for a Joe Biden reelection and no material change of policy – the main alternative of a Donald Trump victory and prospective policy changes would also likely be a 2025 story (here).

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

Source: Datastream, Continuum Economics

The EZ equity market has still not adjusted to the prospect of a H2 2023 recession looking at corporate earnings projections, so some downside exists in terms of expectations in the next 6 months. The ECB and the equity market are underestimating the quick and more powerful than normal impact of the ECB tightening caused by the aggressive pace and also the sharp ECB liquidity reduction due to the roll off of large TLTRO’s. As wage and core inflation comes down, the ECB supertanker should change direction and start delivering rate cuts from Q2 2024. This can more than offset the headwinds from corporate earnings and produce a multiples expansion that helps the market move higher through the course of 2024. Earnings yield to real bond yield measures using breakeven inflation are also favorable (Figure 2). Even so, corporate earnings cannot be ignored, as the EZ recovery will likely be slow growth in 2024, as fiscal policy provides limited support and the lagged tightening effects still dominate in H1. Scope exists for 10% gains in the EZ equity market by end 2024, with ECB easing helping from Q2 2024. The performance of the German equity market will be similar in nature to the EZ equities over the next 15 months.

The UK MSCI earnings recession in 2023 will likely swing towards a modest bounce in 2024 earnings. However, the lagged effects of the 2023 tightening will come through powerfully on mortgages and business investment and this will mean a weak UK recovery. The UK is still cheap however on a 12mth forward P/E ratio basis and against prospective 10yr real yields (Figure 2) where we look for 10yr Gilt yields at 4.10% end 2024. We see the UK market performing alongside EZ equities for the next 6-9 months, as BOE easing will only likely match the Fed and ECB initially. However, H2 2024 should see UK outperformance helped by a Labour majority government being elected, which will provide the long term prospects of a closer economic relationship with the EU. By end 2024, we see 12-15% upside from current levels.

Japan has seen an upgrade of earnings multiples helped by TSE reforms and also the narrative that modest inflation has returned to Japan, which will help nominal corporate earnings. However, we see inflation below consensus in 2024, as we feel a large part of the inflation force will ebb with less post COVID pent up demand/better global supply chains and residual disinflation inertia. This is not good for 2024 corporate earnings or the long-term narrative that Japan can escape the low inflation era. We see scope for 10% gains over the next 15 months, thus merely matching the U.S. equity market.

Emerging Markets 

China’s equity market is undervalued on equity only measures and against 10yr nominal and real yields (see last measure in Figure 3). It could well be that cumulative rate cuts help ignite a shift by domestic players into the equity market, but experience has shown that it normally has to be triggered by excess bank lending growth or aggressive fiscal policy stimulation. However, China policymakers are walking a tightrope between targeted policy support that offsets the negative drag of the residential construction decline (here) versus more aggressive action that could inflate debt/GDP too far and risk a balance sheet recession that means years of ultra-low growth. New policy stimulus will be enough to stop the market falling on our baseline forecast of a slowing to 4% growth in 2024 and could cause intermittent rallies. However, sustained outperformance either needs aggressive resolution of the residential property sector and/or major fiscal policy easing. Neither are likely in our baseline view. Overseas players will remain underweight until a game changer is evident, as they are concerned that the growth and corporate earnings risks are skewed to the downside – our main alternative view is for strong contraction in residential property that leads to a 1-3% growth trajectory in 2024-25 (here). 4% GDP growth in 2024 should be enough at current valuations to mean that the equity market moves higher, as disaster is avoided, but we only see 10% upside by end 2024 and outperformance versus the U.S. is unlikely.

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 

India valuations already show its status as the most loved major EM equity market, due to strong long-term earnings prospects. This sentiment should be reinforced by PM Modi being reelected in the forthcoming general election (expected April-May 2024), which should be followed by market friendly reforms. With overseas investors also wary of China, this means that 2024 corporate earnings growth will likely feed into a higher market. However, the lagged effect of RBI tightening means that 2024 earnings will be circa 15% rather than exceeding 20% and thus we look for 15% upside for India equities by end 2024.

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

 Source: Datastream/Continuum Economics

Brazil remains our favorite major equity market, as 10yr government bond yields point to the prospect of a decline in earnings yield via a multiple derating (Figure 4). Indeed, we see scope for the BCB to reduce the policy rate down to 9% by end 2024. Combined with fiscal consolidation efforts by the Lula administration, plus a better relationship between the central bank and the government, the prospect is that 2 and 10yr nominal yields can fall below 10% -- this all has echoes of the 2011-12 BCB easing cycle. It is certainly the case that 2024 corporate earnings prospects will only see small growth due to the lagged effect of the BCB tightening, but the equity market is more likely to focus on the substantive change in policy rates and yields that will come on a regular basis. Thus we see 15-20% upside for Brazilian equities over the next 15 m