European equities: positive month of July, especially for EMU equities
The US economy reached pre-pandemic activity levels in Q2. This is not yet the case for the Euro area. Although the pandemic prevented the economy from fully recovering last winter, economic activity rebounded significantly in Q2 2021, once social distancing measures had been softened, allowing services to catch up. In the manufacturing sector, on the contrary, production remains impaired by supply-side constraints, which are hampering inventory rebuilding.
We nevertheless expect the recovery to continue on the back of a continuation of easing social-distancing measures in the coming months, which should result in a sharp improvement in household confidence while fuelling consumption, with equipment investment bound to follow the pick-up in demand on the back of easing credit conditions.
Additional support is coming from the endorsement of most EU member states’ recovery and resilience plans by the European Commission, the accommodative positioning of the ECB to preserve favourable financing conditions, and the previously announced adoption of a symmetrical inflation target of 2%.
In this context, we expect growth of around 5.1% in 2021. Despite this attractive growth rebound, the labour market remains far from normal. Employment has troughed, but still has a long way to go to retrieve pre-crisis levels.
The past month was again slightly positive for European markets, especially the EMU. Growth continued its catch-up against value but, unlike in the US, there was no real performance difference between large and small caps. Sector performances were also quite comparable, with the exception of energy and consumer staples, which lagged.
The excellent earnings season was highly supportive of markets. More than 65% of Stoxx 600 companies reporting by the time of writing had beaten earnings estimates. Earnings growth for these companies surprised positively by more than 20%. Energy and industrials especially did extremely well.
As a result, earnings continued to be revised upwards, both in the EMU and in the UK. Consensus earnings growth expectations are close to 25% for both markets for the coming 12 months and, even for 2022, expectations are double-digit. Earnings expectations for both 2021 and 2022 have continued to recover, but are not yet back to pre-crisis levels, with the exception of the materials sector.
Thanks to continuing positive earnings revisions, valuations have also eased somewhat, remaining above their historic median throughout. The US is still the most expensive equity market, with a 12-month forward price-earnings ratio of 21.9, compared to 18.4 for the global equity market. The EMU and the UK are particularly more attractive, with a 12-month forward price-earnings ratio of, respectively, 16.4 and 12.2.
Equity markets, strongly supported by the outperformance of growth against value, ended last month on a positive note. With regard to our positioning over the past month, our overweight in financials, more specifically European banks, despite declining yields, contributed positively. Our underweights in consumer discretionary, telecom services, media & entertainment and utilities also contributed positively, with the sectors underperforming the broader market. The sole negative contributor was our strong overweight in consumer staples, which we increased last month probably a bit too soon.
In this context, we believe the relative performance rebound of growth against value following the recent interest-rate decline has gone too fast: this will make us further reduce our growth exposure once interest rates resume the uptrend started at the beginning of the year. Apart from that, we kept most of our sector grades stable, with the exception of our view on consumer staples:
- We reduced our overweight in consumer staples (food & beverage and household & personal products) to +1 from +2. The sector hasn’t benefited from the declining interest rates, and earnings publications were mixed. L’Oreal, for instance, did very well, while Reckitt Benckiser earnings were negatively impacted by the increased commodity costs.
- We are maintaining our overweight in financials, more specifically, banks. Insurers are still having a difficult time, while banks continued the uptrend that dates back to the beginning of the year. Banks are also still very interesting from a price-to-book perspective, while easing regulatory risks offer us more visibility on future earnings.
- We remain negative on consumer discretionary, a very expensive sector. We are more specifically negative on automobile & components, as the megatrends in the sector (electrification, autonomous driving, etc.) will require OEMs to make large investments that will weigh on their margins.
- We remain cautious on both telecom services and utilities.
US equities: US economic activity exceeding pre-pandemic levels
US economic activity exceeded its pre-pandemic levels in Q2. We expect strong consumption and investment to continue to support economic growth, as the rebalancing towards services continues, underpinning strong consumption, and business investments should remain robust. The exception concerns residential investments, given rising prices and a decrease in house affordability.
In the meantime, the US Senate has voted to push ahead with a bipartisan infrastructure plan, although there are still several obstacles to be overcome. Many parts of Biden’s agenda have been left of out of the deal, including broader action on climate change (in addition to the already-announced measures) and human infrastructure measures, such as an expanded child tax credit and care for the elderly.
In this context, we economists expect around 6.2% growth in 2021 and 4.3% in 2022. With regard to Fed policy, we believe the Fed will wait for further progress in the labour market before tightening its policy.
The past month was again slightly positive for US markets. Growth continued its catch-up against value, while quality big caps especially supported market performance. The excellent earnings season was highly supportive of markets. More than 85% of S&P 500 companies having reported by the time of writing had beaten earnings estimates. Earnings growth for these companies surprised positively by more than 15%. Materials, Industrials and Financials did extremely well, with all remaining sectors reporting double-digit growth as well.
As a result, earnings continued to be revised upwards. Consensus 12-month forward earnings growth expectations are close to 20% for the US market this year and, even for 2022, expectations are double-digit. Earnings expectations for both 2021 and 2022 are now back above pre-crisis levels, and almost all US sectors contributed to that.
Thanks to continuing positive earnings revisions, valuations have also eased somewhat, remaining above their historic median. The US is still the most expensive equity market with a 12-month forward price-earnings ratio of 21.9, compared to 18.4 for the global equity market.
In a slightly positive month for US markets on the back of declining interest rates and a strong earnings season, large caps outperformed small caps while the utilities and financials sectors outperformed. Banks held up quite well, despite the recent yield decline, and could outperform again. Healthcare, too, outperformed the broader market without clear triggers, catching up on the YTD underperformance. Vaccine developers helped drive the sector higher again and earnings were decent. Energy and consumer discretionary lagged the broader market last month. All our positions contributed positively to relative performance, with an overweight in banks and healthcare, and an underweight in telecom services. In this context, we made no strategic changes:
- We remain neutral materials. The risk/reward ratio is bad, valuations are high and commodity prices are now, in our view, reaching their short-term high. Most commodity prices are above pre-pandemic levels.
- We have kept our strong overweight on banks, whose recent resilience convinced us that the sector can continue to outperform in the coming months.
- Despite good earnings, we have kept our neutral grade on IT. 10-year yields are too low and should increase to at least 1.75%. However, this remains a purely tactical call, as we remain very bullish on the sector from a long-term perspective, still very comfortable with its demographic, technological and environmental drivers.
- We have kept our neutral grade on consumer staples. It is too soon to increase to an overweight, and low valuations justify a neutral weighting.
- We remain negative on telecom services. Despite the massive underperformance, we see no trigger for a rebound.
- We remain neutral on consumer discretionary. For us, this is clearly a sector in which stock-picking is vital.
Emerging Markets: still confronted with high reproduction rates
July was a volatile month for emerging markets, with the MSCI EM index correcting by 7% for the month, and EMs ending up giving up all gains for the year. The correction was led largely by China, where increasing regulatory tightening led to a sharp correction in Chinese equities, particularly those in After-school-tutoring, healthcare, property services and technology sectors with a primary US listing. While the first round of the sell-off was triggered following a ban on Didi’s ride-sharing app, just days after its US IPO, the second round was sparked when regulators imposed a non-profit conversion of companies in After-School Tutoring. Regulatory uncertainty saw the MSCI China register one of its worst months in a long time, losing about 14%.
In other EMs, the environment remained tepid, clouded with concerns around rising Delta variant cases, the fall-back in vaccination programmes and policy normalization by some EM central banks ahead of growth recovery. While Taiwan lost 2.8% for the month, Korea ended 5.4% lower and India flat, at 0.9%, leaving the MSCI EM Asia lower, at 8.4% for July. LatAm also gave up recent months’ gains as commodities continued to cool off. EMEA managed to hold its ground (-0.5% for the month), with Egypt and Turkey amongst the month’s best EM markets.
On the currency front, a basket of EM currencies lost 1% in July, whereas, in the commodities complex, Brent oil ended the month at $75.38/bbl, as OPEC allies eventually reached an agreement to increase output.
Couple of changes: Brazil downgraded from OW to N; amongst sector upgrades, Tech Hardware & Equipment, to +1 from 0.
China: maintaining a neutral view.
While the near-term outlook remains clouded by regulatory uncertainty and policy risks, the long-term outlook remains attractive, and a discounted valuation is driving our neutral view on China.
Near term: regulatory tightening continues to weigh on sentiment. Additional risk from delta variant-induced restrictions looks like adding to concerns about GDP growth. On policy: in continuation of general easing and an accommodative policy coupled with a targeted tightening stance. Given the tighter regulatory controls, however, going forward, policy could be eased. China remains a policy-driven market – and near-term policy uncertainty is reflected in the higher equity risk premium, not least in index heavyweight the tech sector.
Maintaining our preference for exposure via onshore/ A-market and avoiding offshore/ ADRs.
Rating changes:
Brazil
We downgraded Brazil to 0 (from 1) which is more of a top-down view; with global growth expectations nearing peak, and commodities going down, our view is driven by the belief that these factors could weigh on Brazil’s commodity-correlated market performance in the near term.
Tech/ Hardware:
We upgraded the tech. hardware subsector to 1 (from 0), as that the sector is becoming attractive again, after its previous consistent performance in a low-growth environment. That view is also in line with the IT sector OW.
- We have kept our +1 on Mexico, which should benefit from the ongoing value run and US recovery, due to cyclicals versus ESG considerations. The incumbent losing their qualified majority (2/3) in Congress (keeps single majority) reduced policy uncertainty.
- We confirm our upgrade on Emerging Europe from -1 to neutral on growth recovery – vaccinations/COVID – Europe – commodities. However, stock selection remains key.
- We remain Neutral ASEAN, where COVID is also impacting the re-opening and which is not fully profiting from the global growth and value recovery.
- We remain Neutral India, after the recent strong market recovery following the weakness on serious COVID resurgence, due to rich valuations and currency risk; the market has been flat since our upgrade to Neutral.
- We remain Neutral Taiwan, due to structural growth stories. Deep cyclical tech geo-political risks, though, prevent us from going OW.
- We remain OW (+1) Materials, on expected strong long-term supply/demand support; however, some ST profit-taking after the strong performance is not excluded. Winners are being trimmed.
- We remain Neutral Healthcare. However, we are long-term positive and there is potential for an upgrade after a period of weakness.
- Although we remain OW Semiconductors & Equipment, based on the strong positive supply/demand momentum, some ST profit-taking after the strong performance is not excluded.
Finally, we continued to keep a balanced portfolio, combining value/cyclical and ‘opening-up’ exposure with quality growth stocks and sectors (technology, healthcare, CD) somewhat protecting the portfolio from profit-taking in more interest-rate-sensitive and longer-duration growth stocks, which came under selling pressure towards the end of the month. As a result, in terms of styles, we are more balanced between growth/value and cyclicals, and are reducing momentum bias as a funding source, despite our longer-term positive view.
