Equity Strategy
Stabilization in bond yields, if confirmed, will go a long way to support stocks
We argued two weeks back that the spike in bond yields was showing signs of getting stretched, and that bonds were entering oversold territory - see October Chartbook. Around that time, our credit team highlighted that the sentiment in credit has likely become too negative - see their report. We remain of the view that the rise in bond yields likely got overdone, our fixed income team has end-year targets for all key markets at long end either flat or lower than current. If bond yields are stabilizing, that will help equities, through allowing the cycle to look more sustainable, through reducing pressure on AI funding, as well as on consumer finances, and through reducing the drive for P/E compression. Indeed, during the most intense phase of yields spiking, forward P/E for AC World fell by 3 points, for SPX by 3 points and for Europe by 2 points. The multiple compression might not need to continue. Short rates adjustment has largely happened. It was the move in fed funds futures that pretty much fully explains the move in 10-year yields so far this year - see top chart. We do not look for further repricing of the fed rates, at least not relative to what the market is already factoring in. If this proves correct, the bulk of the upward pressure on long rates might ease. Inflation expectations are staying largely well behaved, looking at consumer surveys, and at market pricing of inflation, which is also not moving much. The latest inflation prints have been on the hot side in the US, but core inflation runrate that was seen in the months ahead of the start of Iran war is in Europe similar to the period after it, and only somewhat higher in the US, by 0.3%. PPI upmove is so far largely contained in energy-related components. Both the wage growth and wage expectations are staying soft. Looking at bonds demand-supply, our house view is that AI issuance is unlikely to crowd out government bonds. Further, FCF of hyperscalers might end up looking better than current projections once the results hit. Also, the evidence of disruptive/disinflationary impact of AI on parts of the economy is likely to build, probably earlier rather than later. France remains a concern, with difficult adjustment that is needed. Having said that, we do not believe the market should position for contagion. ECB has tools in place to be a credible backstop, Banks’ balance sheets are in a much better shape now than during the Euro debt crisis, their holdings of government bonds are less concentrated, and credit defaults are significantly lower. Alongside potential easing in bond yields pressure, where market breadth has narrowed as yields spiked, and vice versa most recently - see bottom chart, we are looking for a reassuring Q3 reporting season - see our report from last week. The earnings season is in the early stages, with 29 US and 14 European results so far. The concern by investors is that delivery might underwhelm, but so far the majority of results were “beat and raise.” The stock price reaction is more mixed in the US, but in Europe the stock price reactions, even to the mixed delivery, the expected weakness in consumer space is indeed a soft spot, have not been too negative, see for example LVMH. Oil price is a wild card, but if bond yields and earnings deliver as we expect, then equities will be able to perform into year end, in our view.
Stabilization in bond yields, if confirmed, would go a long way to support stocks
Two weeks ago, we called for bond yields to stabilize
Bond yields have sold off sharply this year. In late September, the US 10Y yield crossed 5% for the first time in two decades, peaking around 5.3%. The drivers were a combination of higher energy prices, strong PMI components and hawkish comments from Fed governors.
Two weeks ago, in our October Chartbook, we argued that the bond sell-off was nearing exhaustion and that yields should stabilise. At recent lows, Bonds’ RSIs reached oversold levels before rebounding.
The move in fed funds futures explains almost all of the rise in 10Y yields this year. Long-end yields have not moved independently of the front end. We believe this was a repricing of the policy path, not a loss of confidence in inflation or fiscal credibility.
Fed funds futures have moved up by almost 200bp this year, but they are no longer rising. At end September, markets were pricing 39bp of further hikes by year end, but have since receded to around 26bp.
The term premium is no longer rising. This supports our view that the last leg of the sell-off was largely driven by the policy path.
Our credit team has also flagged that sentiment in credit has likely become too negative.
Our fixed income strategists’ year-end targets for long end yields are below current levels in every key market. They expect the US 10Y at 5.05% by December and the Euro Area at 3.15%. The biggest declines are expected in the Euro Area and the UK at 22bp and 24bp, respectivelyt
Our economists expect the fed funds rate to go from 4.00% to 4.25% in December and then stay on hold thereafter. Even the hot CPI print did not trigger any meaningful market repricing. We do not expect the fed to be repriced relative to what the market expects. If this proves correct, most of the upward pressure on long rates should ease.
The ECB deposit rate is expected to go from 2.50% to 2.75% in December and to 3.00% by March.
Inflation expectations are staying well behaved
Consumer surveys show expectations remain anchored.
Inflation forwards have held steady and have even edged lower in recent days, even though Brent has climbed back to around $105.
Both wage growth and wage expectations remain soft, and labour markets are mixed. Without wage pressure, we believe the energy shock is unlikely to turn into persistent core inflation.
The latest U.S. inflation prints have been on the hot side. Even so, the core run rate is only 0.2pp above its pace in the months before the war.
Europe has also seen a modest uptick in inflation trends. This is far from the broad inflation acceleration that would justify another leg higher in long yields.
AI issuance is unlikely to crowd out government bonds
Hyperscaler FCF is forecast to turn negative in 2027, which suggests that funding from credit markets is likely to drive more of the AI buildout going forward.
Our house view, however, is that it is unlikely to crowd out government bonds. Our credit team expects the market to absorb the extra supply with only a limited impact on spreads. Our Cross-Asset team estimates that the roughly $260bn of additional high-grade supply would lift yields by only about 5-10bp.
Credit spreads have widened in recent weeks but remain contained by historical standards. The move reflects a repricing of yields and political risk, not a fundamental deterioration in credit. With sentiment likely too negative, spreads should tighten if yields stabilise.
Consumers will also see relief from lower yields
U.S. consumers have so far been resilient in the wake of pressures arising from higher borrowing costs and rising fuel and energy bills. However, the pressures are building.
Savings built up during the pandemic have largely run out.
Lower-income households are feeling it the most, and the strain is starting to show in more cautious spending and rising credit card balances.
Lower yields should offer some relief. A pullback in Treasury yields would ease mortgage rates and other borrowing costs, help households refinance and support confidence through higher asset prices. That won’t fully offset the energy shock, but it should soften the blow to spending in the coming months.
Stabilizing yields would ease concerns around equity multiple compression
Historically, higher bond yields have generally been favourable for equity multiples, with both showing directional correlation. However, the relationship tends to flip at higher levels of yields.
As yields climbed this year, forward P/E multiples have compressed by around 2 points for both MSCI World and the S&P 500, while MSCI Eurozone fell from 14.8x to 14.0x. The S&P 500 now trades on 19.1x 12m forward P/E, compared with 14.0x for MSCI Eurozone.
Lower yields are supportive for the broadening trade
Over the last few months, market breadth has once again become quite narrow, with S&P500 strength driven by a small set of companies. We believe that higher yields pushed investors into the AI / momentum trade.
As yields come off their highs, the equal weighted S&P500 index is outperforming once again. Higher yields hurt the median company more than cash-rich mega caps, given their greater sensitivity to funding costs and to the consumer.
Fundamentals also support broadening. The share of global companies with accelerating earnings is near record highs, which improves the odds of a more sustainable upcycle. By contrast, Mag 7 are flat year to date. We have argued that the market does not need Tech to outperform in order to move higher. Lower yields and broadening earnings make that case stronger.
France remains a concern, but we would not position for contagion
French political instability has weighed on French equities, lagging their Eurozone peers for more than two years. Year to date, the CAC40 is down 2.6%, while Euro stoxx is up 6.2%.
French 10Y debt now yields 140bp more than Bunds, the highest levels since the Euro debt crisis in 2012. Investors remain concerned about the fiscal path, while the May 2027 presidential elections and and the global bond sell-off are exacerbating the moves.
The de-rating has been fast. French stocks have lost 9%+ relative to the market year to date. On 12.9x forward earnings, the CAC40 trades at a 7% discount to MSCI Eurozone at 13.9x. With relative P/E at record lows and spreads close to record wide, we think a lot of the bad news is in the price.
The CAC 40’s relative performance has lagged its relative forward EPS, which suggests the market is penalizing the index despite resilient earnings. We believe this could end up being an opportunity.
French Banks in particular have lagged their peers. Our Banks analysts see the wider spread mainly as a hit to sentiment and multiples, not to balance sheets. Sovereign books are largely hedged and held in held-to-maturity accounts, and liquidity and funding look manageable. If conditions tighten further, the channels to watch are funding mix, asset quality and bank tax rhetoric.
The link between sovereigns and their Banks has weakened. French Banks’ domestic government bonds are 18.2% of assets, down from 20.4% in 2012. Our analysts expect higher yields to have little mark-to-market impact on capital. Bank bond holdings are much more diversified now than they were in 2011–2012, so any rise in yields is unlikely to do meaningful damage to capital ratios.
Loan books are in much better health. The Euro area NPL ratio is 1.8%, well below the 8.7% seen at the peak of the crisis.
Banks are much better capitalized as well.
The ECB backstop is also another critical difference. Then, the ECB tightened into the stress and built its tools as spreads blew out. Markets turned only after the July 2012 “whatever it takes” pledge and OMT. Today, the tools exist in advance, and TPI was designed for exactly this kind of disorderly widening. That makes a sovereign bank feedback loop much less likely.
The caveat is that TPI access depends on compliance with EU fiscal rules, and France is under an excessive deficit procedure. We see this as a reason for a lasting risk premium, not for contagion.
Q3 reporting season has been off to a reassuring start
Reporting season is still at a very early stage, but the early read is encouraging. Of the 6% of US and 3% of European companies that have reported so far, 78% and 60% respectively have beaten consensus expectations, including ASML and the US banks. Overall, European companies are doing better than their US peers so far. European companies have also seen a better share-price reaction on results day, outperforming by 0.9% on average, compared with -0.5% in the US.
Investors’ main concern is that actual results might underwhelm. So far, price reactions even to mixed results have not been too negative, particularly in Europe, as LVMH showed. Most companies have beaten EPS estimates, and the average share-price reaction across both beats and misses has been +0.9%. We think this reflects cleaner positioning after September’s volatility.
In the US, the market is less forgiving. Misses have been punished by more than the historical average, at 1.9%, and even beats have seen stocks underperform by 0.7%. Banks, in particular, have been penalized even though they reported higher headline EPS.
Consensus looked demanding going in, but the hurdle is lower beneath the surface - see Q3 preview. S&P500 Q3 EPS growth is projected at 24%, falling to 15% excluding Nvidia and Micron and to 8% for the median stock. In Europe, 19% growth falls to 11% excluding Energy, with the median at 9%.
Appendix
Equity Strategy Key Calls and Drivers
Equities got hurt by the spike in bond yields, but we do not think this will persist. First, historically, the start of Fed tightening was a confirmation that the economy was strong, rather than a signal to sell. We expect continued robust earnings delivery, with Q3 results starting next week, EPS revisions remain in positive territory in most places. This is aided by a rebound in PMIs, even in challenged areas, such as Eurozone. Our lead indicator of earnings is staying on an uptrend. The spike in bond yields, the key headwind for stocks, might be getting stretched. Bonds are close to oversold territory, and we note fed funds futures, which made a huge, almost 200bp, move up ytd, are not increasing anymore. Crucially, we do not see inflation expectations becoming de-anchored, the differences to 2022 template remain big, in terms of Tech outlook and the inflation/wages/labour backdrop. Beneath the surface, we favour the Tech sector. Also, in the past 3 months, during the spike in yields, market internals remained largely risk-on, with Cyclicals top in Europe, and all Defensives behind. Market recovery will likely see Cyclicals favoured further. French political risk will likely not go away. Having said that, CAC40 has already done poorly, spreads are near record wide, and CAC40 P/E relative is at record lows – a lot is in the price.
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Akzo Nobel(AKZO.AS/€59.00/OW), Alstom(ALSO.PA/€16.13/OW), Anheuser Busch InBev(ABI.BR/€73.92/OW), Arkema(AKE.PA/€56.15/UW), Auto Trader(AUTOA.L/546p/UW), BASF SE(BASFn.DE/€52.97/UW), Brenntag SE(BNRGn.DE/€64.66/UW), Brunello Cucinelli(BCU.MI/€87.28/OW), CTS Eventim(EVDG.DE/€60.70/OW), Carrefour(CARR.PA/€16.61/UW), Clariant(CLN.S/CHF10.62/OW), Coca-Cola Hellenic Bottling Company(CCH.L/4,426p/N), Croda(CRDA.L/3,623p/OW), DSM-Firmenich(DSFIR.AS/€107.15/UW), Danone(DANO.PA/€61.56/OW), Dassault Systèmes(DAST.PA/€23.10/N), Demant A/S(DEMANT.CO/Dkr358.80/OW), Deutsche Bank(DBKGn.DE/€29.02/OW), ENI(ENI.MI/€25.95/OW), Epiroc(EPIRa.ST/Skr264.30/OW), Essity(ESSITYB.ST/Skr277.50/UW), Evonik(EVKn.DE/€21.32/ UW), Fresenius SE(FREG.DE/€44.82/OW), Fuchs(FPEG_p.de/€38.60/OW), Galp Energia(GALP.LS/€22.65/OW), Givaudan(GIVN.S/CHF3,930.00/OW), Haleon(HLN.L/375p/UW), Heineken(HEIN.AS/€75.94/N), IMCD(IMCD.AS/€104.15/ UW), ING(INGA.AS/€30.17/OW), JCDecaux(JCDX.PA/€25.86/OW), Jeronimo Martins(JMT.LS/€18.18/OW), Kerry Group(KYGa.I/€94.40/OW), Koninklijke Ahold Delhaize NV(AD.AS/€32.31/UW), Legrand(LEGD.PA/€134.00/OW), Lindt & Sprüngli (LISN)(LISN.S/CHF87,400.00/UW), Moncler(MONC.MI/€43.25/OW), Natwest Group(NWG.L/666p/OW), Nestle(NESN.S/CHF81.98/OW), Novonesis(NSISB.CO/Dkr454.80/OW), OMV(OMVV.VI/€73.90/UW), Pernod-Ricard SA(PERP.PA/€68.22/N), Puig Brands(PUIGb.MC/€19.63/N), Richemont(CFR.S/CHF176.50/OW), Sage(SGE.L/1,122p/OW), Siemens Energy(ENR1n.DE/€132.40/OW), Solvay(SOLB.BR/€25.18/OW), Standard Chartered(STAN.L/2,127p/OW), Syensqo(SYENS.BR/€81.00/OW), The Magnum Ice Cream Company(MICCT.AS/€16.69/N), TotalEnergies(TTEF.PA/€80.71/ N), UBS(UBSG.S/CHF39.80/OW), Umicore(UMI.BR/€20.54/OW), Unilever NV(ULVR.AS/€58.94/OW), Unilever plc(ULVR.L/4,966p/OW), Vestas(VWS.CO/Dkr189.95/OW), Wacker Chemie(WCHG.DE/€87.80/UW), Weir Group(WEIR.L/2,682p/OW), Yara(YAR.OL/Nkr412.10/UW), YouGov(YOU.L/292p/OW), Zegna Group(ZGN/$12.91/OW)
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