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30 March 2021

A Rising Yet Bumpy Path Ahead

Equity markets have been in a goldilocks environment in recent months. The combination of rising inflation expectations and falling real yields has supported earnings expectations on the one hand and valuations on the other. While we think that inflation will continue to move higher and remain upbeat on the earnings outlook for the months ahead, real rates are set to turn from tailwind to headwind. As long as real rates rise only gradually – as is our base case – the upside for equities will prevail. At the sector-level, however, this may come with a change in leadership and a road ahead that may not be as smooth as it has been over past months.

A lot has gone right for equities

A lot has gone right for equities over the past few months. The release of various vaccines since the beginning of November, a US election outcome which allows for substantial fiscal support and a positive Q4 earnings season have reinforced the perception that the equity market recovery is more than just hot air.
US earnings for Q4 2020 eked out a small rise over Q4 2019 results, which is remarkable considering that 2019 was completely unaffected by COVID. At the same time, European earnings also came in above expectations.
More fundamentally, the market’s key drivers remained firmly in place, keeping the goldilocks environment for equities alive. Central banks left no doubt that they would continue to provide monetary accommodation until inflation has firmly accelerated to 2% or higher, putting speculation about a premature tightening to rest. As a result, real rates declined, while inflation expectations continued to rise.
Equities were the key beneficiaries as lofty valuations were sustained by lower discount rates, while consensus earnings expectations saw further upgrades.
A goldilocks environment for equities
Source: Refinitiv, Bank J. Safra Sarasin Ltd, 19.02.2021
The current situation defies the typical seasonal pattern. Usually, earnings expectations enter the year at elevated levels only to see reality seep in and downgrades take hold. Downgrades usually trough at the end of Q1, before they stabilise towards the end of the year.
Strong earnings momentum going into 2021
Source: Refinitiv, Bank J. Safra Sarasin Ltd, 19.02.2021
We think the market is right to believe that economic activity will bounce back once restrictions are lifted. A massive accumulation of household savings in the US and in Europe, combined with unprecedented fiscal and monetary support, should help growth to accelerate. Based on our GDP growth forecast of 6.9% for the US in 2021, earnings expectations are set to gain 10%-15% until the end of the year.

Fed tightening expectations are a risk

In the absence of any unknown risk events, the biggest challenge to further market upside, in our view, is a US economy that is running too hot with a concomitant rise in expectations for policy rates. Given that much of the equity recovery in 2020 has been a function of falling real yields, which typically move in lockstep with implied Fed Funds rates, an abrupt change in the Fed’s dovish messaging would likely derail the equity recovery by compressing valuations. In a more benign scenario, which is our base case, real yields grind higher as expectations for monetary tightening slowly build up in light of improving economic data.
Equity valuations benefit from low real yields
Source: Refinitiv, Bank J. Safra Sarasin Ltd, 19.02.2021
Market upside should prevail in such a scenario as headwinds for valuations remain moderate. In both scenarios, we believe the most promising strategy to be a sector allocation that benefits from higher inflation expectations and is immune to a rise in real yields.
Real yields partly reflect Fed expectations
Source: Refinitiv, Bank J. Safra Sarasin Ltd, 19.02.2021

Position for a reflationary environment

Consequently, we prefer banks and other financials as they tend to benefit from rising yields, no matter if the increase is driven by inflation expectations or real yields. Among all sectors, they are the main beneficiaries of rising rates as their earnings are closely related to the level and the steepness of the yield curve.
Banks benefit from a steeper yield curve
Source: Refinitiv, J. Safra Sarasin, 19.02.2021
On the other hand, we are cautious on defensive long-duration sectors, given the vulnerability of valuations if real rates move higher. Typically, this includes consumer staples, utilities or health care providers. Although they may have sound business models and stable long-term earnings prospects, they tend to underperform when discount rates rise.
In our view, a growing part of the tech universe should also be considered defensive. While tech earnings continue to grow at an impressive pace, 2020 has also shown that the sector is incredibly resilient to economic setbacks. As a result, valuations have surged on the premise that earnings are more stable than previously assumed. This comes with a drawback though. The sector appears more sensitive to adverse rate moves than in the past. At the current juncture, this may result in increased headwinds for tech, while other, more cyclical sectors, should be less affected. The long-term outlook for tech, however, is positive. The sector’s ability to generate and sustain superior earnings growth will support its structural attractiveness.
Tech has become increasingly defensive
Source: Refinitiv, Bank J. Safra Sarasin Ltd, 19.02.2021
For the equity market in general, short-term setbacks are likely over the coming months as the repositioning at the sector level will be accompanied by volatility, but the projected strong recovery in macro data still implies upside until the end of the year.
We project the S&P 500 to reach a level of 4100 by the end of 2021, supported by a strong recovery in earnings expectations, which should more than offset the expected de-rating of price-to-earnings multiples.

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