In the first half of August, stock markets rallied, being supported by improving financial conditions. This is not to continue as the Fed recently signalled to undertake everything in their power to combat high inflation, thus also indicating that yields are to remain high for longer. In this situation, the market may be tempted to price in a more severe economic slowdown, with equities suffering, especially over the next 3-6 months.
Furthermore, we see PEs to derate due to low confidence and a resumed deterioration in financial conditions. Earnings eps dispersion is trending down, just like the bond volatility (MOVE) and VIX/MOVE: all leading to downward pressure on the ERP. Global growth momentum will likely continue fading, which market has yet to discount. So far, Q2 earnings held well but macro surprises are falling and both real income and global activity deteriorate.
Decent Q2 season: seeds to future lower growth
The Q2 reporting season (almost over) in the US was a decent quarter with earnings surprise at 4%, which is close to the historical average (ca. 5%). With the surprise average over the last 9 quarters being at 13%, Q2 is trending to a more sustainable lower number. European companies have continued to deliver stronger earnings than expected by analysts (surprise of 10%). Overall, as Q2 GDP was very much subdued, so did eps growth of corporates ex-energy. Thus, weighted average of sectors ex energy was only slightly positive (+0.3%) in the US (+7.5% for Europe).
The margins trend is down but mostly due to high sales growth. Banks pushed up cost of risk in order to be more cautious (precautionary attitude). CPI/ULC 1- year change is going down and should lead NIPA margins downward by 1-2pp in 1 year. ISM new orders is signalling 12-month eps momentum (3m change) to break the zero line soon. Capacity utilization momentum is trending down, too, usually correlated to ROE and margins (to trend lower). Global revisions (MSCI World) are in negative territory for the first time since 2020 but yoy changes of revisions are already very low, near a cyclical through, so we could see some relief short term also because the market already discounted a big EPS slump in the months before. Overall, we see declining EPS momentum in progress. We expect margins to continue staying under pressure and see earnings deterioration ahead, thus maintaining our earnings forecast below analysts’ expectation in 2022, 2023 and 2024.
Within countries we continue to set on UK vs. EMU, remaining neutral on Japan, and UW on SMI. EMU equities start to look attractive vs US ones: better internal country score, higher results from our short- term models as well as slightly better adjusted PEG ratio (1.7 vs 1.75). Given the still dormant gas supply related risks, we prefer to remain neutral on EMU vs US. As for sectors, we decrease an UW for RE, following the recent significant underperformance, and go OW on Healthcare Equipment.
According to our machine-learning models, the sector looks significantly undervalued now (Z-score of 4.2), while earnings revisions are about to turnaround. Other OWs are durables (lower), div. financials, energy, food, and software. The sectors on UW are capital goods, comm. Services (higher), insurance, media, pharma and transportation. We continue to implement a small overlay to our sector allocation with style bets: OW Defensives and Growth/Value.
EM: neutral. Pressure from falling macro surprises
EMs are to be pressured by falling macro surprises and decreasing exports orders in the short-term. Beyond, valuation gap, higher long-term earnings growth (vs DMs) and increased yield gap vs US HY could trigger an extended EM outperformance. Last week, the State Council in China increased its policy easing measures. We continue to overweight Chinese equities, while recognizing the need to monitor risk related to China’s property market.