European equities: what to do if the Fed starts hiking
* Future markets imply a probability of 30% that the Fed will start hiking interest rates today – and a probability of around 60% for a rate hike by the end of the year.
* We think a rate hike now would be a mistake, as inflationary pressures are low, market-implied inflation expectations have dropped to levels at which the Fed has started easing in the past and financial conditions have already tightened significantly (the St. Louis Fed Financial Stress Index is at the highest level in 4 years).
* After Fed hikes in 1994 and 2004, US equities have typically dropped by around 7% in the first two months. This correction has been driven by P/E falling by around 15% (in line with rising US 2-year note yields), while earnings growth remained strong. Performance for European equities has been slightly weaker, as they de-rated sharply after the 1994 hike, on the back of elevated starting valuations.
* In the current cycle, we believe there is less downside to P/Es (as short-term rates are set to rise by less than on previous occasions), but also less upside to earnings. When the Fed starts hiking, we think equities could correct by 5% to 8%.
* European equities have potential to outperform US equities in such a scenario, in our view, given attractive relative valuations, tailwinds from ECB easing, more earnings rebound potential and a likely further appreciation of the USD (as a result of a further rise in the bond yield spread between the US and Europe, which only tends to reverse once relative Fed tightening stops).
* Among European sectors, banks, tech, utilities and insurance have historically performed well after past first Fed rate hikes, are positively correlated with the USD & the 2-year US note yield and offer attractive relative valuations.
* Our basket of European companies with US exposure has already performed strongly and relative valuations look expensive in aggregate. We show a screen of companies with high sales exposure to the US whose P/E relative to the market is below the long-term average. Of those Aegon and Qiagen are buy-rated by our analysts
* Economic pressures on emerging markets are set to increase following a Fed rate hike, as capital outflows accelerate and a strong USD weighs on commodity prices. Our GEM exposure basket has held up surprisingly well, given the relative slow-down in emerging market GDP growth – and the basket continues to look expensive on relative P/E. We show a screen of GEM-exposed stocks whose P/E relative to the market is above the long-run average. Of these, Telefonica is sell-rated