Equities Seeking Direction

Equity markets have been choppy so far, after the H1 rebound as a partial reversal of 2022 steep selloff. What are the prospects for the remainder of the year? 

Figure 1: Q3 Equity Market Performance QTD (%) 

Source: Bloomberg/Continuum Economics 

U.S. Better/Europe and China Nervous 

Q3 has seen a choppy performance with up down and up phases, but of the major market the U.S. has performed the best. The sense that the U.S. can avoid a recession and will likely see a soft landing has prompted a sense that the worst of the earnings news has been seen in 2023 and that bottom up expectations of 12% earnings growth in 2024 help to underpin the market. Additionally, AI euphoria is also a driver in sentiment towards the mega cap tech stocks, which is also driving up the overall SP500 index.  Looking at investment grade/high yield spreads (Figure 2) or fund flows it also seems that financial conditions are not tightening too rapidly for weaker borrowers. 

The remaining months of the year will likely be tricky however, as the U.S. equity market is now biased to good news and is vulnerable if the lagged effects of Fed tightening cause an unexpected slowdown into Q4 and 2024. Economists are split with the majority biased towards the soft landing view, but some concerned about the risk of a slowdown. So far interest rate sectors have proved resilient in the face of Fed tightening, but the uncertainty is the lagged effects of an aggressive tightening cycle could cause nonlinear effects in the economy and financial markets. This puts a premium on data watching in the coming months, as Fed policy is now unlikely to be the driver. The Fed is going into slow motion with a likely pause in September; probably hike in November and then guidance that rates will remain high. We see only slow progress for core PCE inflation to come down, which means that real sector data could become key for equity market sentiment. While we do see a hard landing in the U.S., we feel that sentiment is too optimistic at the moment on a clear soft landing. Additionally, forward P/E ratios are elevated at present relative to its own history and to 10yr real bond yields using breakeven inflation. Overall, our view remains that a rotation lower to 4200 remains likely for the S&P500 before year-end. This is tactical rather than strategic in nature however, we continue to forecast 4700 on the S&P500 for end 2024.

Figure 2: U.S. High Yield Spread (%) 

Source: Datastream/Continuum Economics 

Will other major equity markets out or underperform the U.S. in the next few months? EZ equities are nervous about signs of weaker data in the EZ compared to the U.S. This is correct as EZ companies and households have not had an interest rate tightening cycle since 2004-07 in contrast to the U.S. tightening cycle 2018-19. We feel that a mild EZ recession has started, but that money and credit numbers are warning about downside risks for our own below consensus forecasts. Thus we see the Q3 EZ equity underperformance as warranted and likely to continue to a modest degree for the remainder of the year. The ECB is unlikely to rescue sentiment for equities. Though we feel that the ECB has already peaked, the ECB will be reluctant to admit that until the December meeting and will likely not prepare the way for rate cuts until spring 2024.

The other big equity focus is China for global growth and for China equities. Our current 2023 growth forecast of 4.9% is worse than it looks, as the Q1 bounce means that 2023 will be reasonable. Our forecast actually embeds 0.6% for Q3 GDP on a quarterly basis, which is slow for China and reflects the drag from the property sector (here). We actually see downside risks, as the policy response so far has been piecemeal. Policy action should pick up and help Q4 to a 0.8% Q/Q rise, but this is still below a 5% growth trend – hence why we are forecasting 4% growth in 2024. Economic data out of China will likely cause volatility, but more policy action should tend to counteract. We also see China’s authorities likely forcing mergers for weaker financial institutions and arranging restructuring as well.All of this will likely mean volatility, but not a clear trend for China equities. Only aggressive policy action or a policy mistake (e.g. allowing a failure) would be game changers. 

Our favourite major market for the rest of the year is Brazil.Policy rates are so high that the BCB will cut rates by a further 100bps before year-end and continue easing in 2024 (here). Earnings yields normally come down in easing cycle leading to a multiple rerating for the equity market (Figure 3). Fiscal policy is also on a better footing with fiscal consolidation rather than expansion. We still see scope for 10% outperformance versus S&P500 before year-end. 

Figure 3: Brazil 10yr Yield and 12mth Fwd Earnings Yield (%) 

Source: Datastream/Continuum Economics