Equities rose sharply despite slowing earnings momentum and economic data showing US inflation remained high.
After a string of disappointing mega-cap results, signs of Apple’s demand resilience were enough to propel its stock higher, dragging the index in its wake.
Markets were also supported by growing optimism that central banks were slowing the pace of interest rate hikes, similar to the weaker-than-expected 50 basis point (bp) rise reported by the Bank of Canada.
Comments by Christine Lagarde, president of the European Central Bank, that the eurozone could enter recession, and claims by some US Federal Reserve (Fed) governors since their last meeting about the potential for further interest rate hikes moderate, also contributed to this renewed hope.
Alleviating salary pressures
The 10-year U.S. Treasury note yield rose 7 bps after the core personal consumption expenditures (PCE) price index rose 5.1% year-on-year compared with 4.9% year-on-year In August. But ten-year yields continued to fall throughout the week in question.
As with hopes for a change in central bank attitude, other data point to easing wage pressures. The US labor cost index, the broadest measure of labor costs, rose 1.2% in the third quarter, after rising 1.3% in the second quarter.
In this context, wages rose 5.1% year-on-year in the third quarter, compared to 5.3% in the second quarter. Private sector wages rose by 5.2% year-on-year, up from 5.7% in the second quarter.
Drop in oil price
The price of oil fell after China imposed new Covid-19 restrictions in some cities. But despite that, crude oil ended the week up 2.4%.
The dollar appreciated slightly after losing ground. The DXY index closed up 0.1%.
What to expect?
After the recent 4% rise, the S&P 500 is up about 10% from its October 12 low. Much of this movement is attributed to hopes that the Fed may begin to slow the pace of its rate hikes and to technical factors related to investors’ already cautious positioning.
After nine consecutive weeks of capital outflows from global equity funds, investors poured cash back into equities during the week of October 26. According to data from Refinitiv Lipper, net inflows into global equity funds were $7.8 trillion.
Stock volatility also dropped over the week in question: the VIX index dropped from 30 at the start of the week to 26 on Friday. This decline may have triggered purchases through systematic strategies. And market momentum from the mid-October low has likely reached levels that trigger CTA (Commodity Trading Advisors) buys.
Still, while technical factors and shifts in investor sentiment have the potential to drive periodic market rallies, the risk-reward balance at this point is unlikely to favor a sustained rally in equities.
No slowdown in rate hikes
The recent rally in stocks was based on hopes of an imminent change in Fed policy. However, at the November 2nd meeting, the latter decided for the fourth consecutive rise of 75bp.
Despite comments from some US central bank officials about the potential for a slower pace of interest rate hikes, it is probably too early to expect such a change. Inflation remains very high and the Fed sees its credibility at stake.
We can therefore expect him to aggressively maintain his increases until official data shows that inflation is retreating. Even if the Fed stops raising rates eventually, remember that monetary policy is likely to remain at tighter levels for some time to come.
The tech sector disappoints
Meanwhile, the results of mega-caps in the tech sector were disappointing. There has been a further decline in online advertising, cloud spending has dropped, e-commerce is sluggish and cost increases are eroding the margins of many of these companies.
Apple’s results were the best in a string of disappointing tech mega-cap announcements, and its stock rose sharply, contributing a quarter of the S&P 500’s movement. habitual.
Earnings per share down
Third-quarter earnings per share (EPS) for the S&P 500 year-over-year rose below UBS Research’s initial forecast of 3-5%. With 70% of the S&P 500 market caps having released their results, growth is expected to be in the 1-3% range.
Only 64% of companies outperformed forecasts, compared to an average of 75% over the past five years. The magnitude of earnings overrun is also smaller, with aggregate EPS just 1% better than expected, significantly lower than the five-year average of 8%.
Faced with this drop, the pressure on corporate results will undoubtedly only increase in the coming quarters. Therefore, the S&P 500 EPS could drop 4% to $215 next year. In a real recession scenario, the EPS could drop to around $200. This figure can be compared to ascending consensus estimates of $235.
How to invest?
As mentioned above, the risk-reward ratio is unlikely to favor a sustained rally for equities. Investors will need to see the Fed cut rates or a slump in economic activity on the horizon. These conditions are not currently met.
As for valuations, even using the EPS consensus forecast, the S&P 500’s price/earnings ratio has risen to nearly 17x. These valuations are therefore unattractive given the recession risks that remain high and given current bond yields. The spread between the S&P 500 earnings yield and the U.S. 10-year bond yield is now at its lowest since the global financial crisis.
In this context, it is recommended to focus on mitigating short-term downside risks, maintaining upside exposure in the medium and long term.
On the stock side…
Within equities, UBS Research values equity protection strategies, value equities and quality income. In addition, she shows preference for overall health, basic consumption and energy. In contrast, it positions growth, industrials and technology stocks as least preferred.
Low-tech mega-cap earnings support the least preferred technology view. By region, the UK and Australian markets are favored as being cheaper and more valuation-oriented, compared to US equities with more exposure to technology and growth, as well as more extreme valuations.
… and obligations
With respect to bonds, the preference is for high quality investment grade bonds over high yield US bonds. And speaking of currencies, the recent fall in the dollar should not be seen as the beginning of a trend reversal.
Slowing global economic growth and rising US interest rates, with more cautious central banks, still favor the US dollar. The Swiss franc should benefit from its safe-haven status, while exposure to growth-oriented currencies such as the pound sterling, euro or Chinese yuan should be protected.
In commodities, UBS Research favors exposure to crude oil, given expectations that prices will rise to $110 a barrel next year. Click here to learn more about the shift to defensive strategies.