Falling Euro-area real bond yields should allow the equity market to re-rate further: because of the ECB’s hints at further policy easing, 10-year Euro-area real bond yields fell 15bps last week and now stand at around minus 40bps, some 50bps below their August peak. With real bond yields the key determinant of the P/E, the equity market has re-rated to 15.4x 12m forward consensus EPS, up from 13.6x at the end of September. If the ECB acts in December in line with our economists’ expectations (see their report Mutual reinforcements, Oct 23), real bond yields could fall another 30bps, in our view. This would be consistent with European equities’ 12m fwd P/E rising above 16x, a 5% re-rating from current levels. We note that earlier this year, real bond yields kept falling (and the equity market rising) as long as the market was anticipating ECB action – and only started rebounding after the start of the QE program in March.
US recession worries are overdone... : in our meetings, clients’ main focus has shifted from the risk of a Chinese hard landing to that of a US recession. Some of the data do indeed look worrying: a) the inventory to sales ratio has risen to a six-year high and industrial production (IP) growth fallen to a six-year low; b) S&P 500 operating EPS growth has turned negative in Q2, something which over the past 25 years has only happened during US recessions; c) Fed surveys have continued to fall sharply. However, a sufficient number of indicators are pointing to a more benign outcome: a) the Atlanta Fed’s GDP Nowcast suggests inventory run-down subtracted 2 percentage points from growth in Q3, pointing to underlying growth of 3%; b) our economist Torsten Sløk points out that residential investment should contribute 0.75pp to GDP over the coming quarters; c) the historical relationship between the change in the oil price and developed market GDP growth points to upside risks for growth. As the drag from a stronger dollar and the inventory run-down wanes, we think US macro momentum has scope to stabilize. Our economists expect 2.4% US growth this year and 2.5% in 2016.
... yet, the market-implied date for the first Fed rate hike is set to move into H2 2016: markets expect the Fed to start hiking in May 2016. Yet, following the sharp slow-down in macro momentum in Q3 and with the ECB and the PBoC easing and the dollar rising again, we think this will be pushed into H2 2016, further easing global financial conditions. A key risk for equities would be a sharp improvement in US data which tightens financial conditions by making an early Fed hike more likely.