Head of Saxo Strats
Summary: The strong equity rally this year has faded fast in February as bond markets are beginning to second-guess their initial rosy outlook on inflation and policy rates. A significant shift higher in US long-term bond yields has finally spilled into equity sentiment sending S&P 500 futures 2% lower yesterday. High equity valuation themes were leading the declines while commodity related and defence stocks were among the best performing themes. Home Depot and Walmart earnings releases underpinned once again that operating margins are under pressure from higher wages setting equity markets up for more hiccups in 2023.
Equities tumble as long-term bond yields climb to almost 4%
S&P 500 futures declined 2% yesterday closing just above the important 4,000 level as a higher US 10-year yield closing at 3.95%, the highest since mid-November, put downward pressure and breathed new life into the structural inflation and margin compression themes. As we recently argued, the interest rate sensitivity has fallen for the general market compared to a year ago as equity valuations have come lower, but in the various growth segments such as our theme baskets NextGen Medicine, E-commerce, and Bubble Stocks, the interest rate sensitivity was very well alive yesterday down between 3.5% and 5.5%.
The best performing equity theme basket was defence, which we highlighted on Monday on the back of a nervous Munich Security Conference and the upcoming 1-year mark of Russia’s invasion of Ukraine. In the coming weeks geopolitical risks will be on the rise and the key geopolitical risk to consider is whether China increases their commitment to Russia and maybe even supporting Russia with weapons in Ukraine. This is a ‘red line’ for the US and Europe and could cause severe disruptions and mark the end of globalisation. The probability of this scenario is still low, but adding defence stocks to the portfolio would add some hedging against geopolitical risks.
Home Depot and Walmart confirms wage pressures and margin compression
Yesterday’s results from Home Depot and Walmart confirmed that wage pressures are still high with Home Depot setting aside an extra $1bn to their hourly frontline staff. Home Depot’s guidance on operating margin at around 14.5% is lower than the estimated 14.8%. Home Depot is one of the biggest winning stocks of the past three decades in the US equity market and in theory a Berkshire Hathaway acquisition target. While yesterday’s earnings release is a setback for the company and the strong pandemic boom narrative is seeing cracks it will likely be too early for value investors to get into Home Depot shares as the company is still valued significantly above the general equity market and its own long-term average valuation since 2003.
The margin compression theme we have written extensively about for several quarters picked up during the Q4 but overall companies still managed their margins a bit better than feared. However, despite energy and general commodity prices have eased over the past six months, the pressures from wages will begin eating into margins. The equity market’s sensitivity has moved from interest rates to that of operating margin because companies’ margins are rolling over from historically high levels.
The worst-case scenario this year for equities is if the bond market wakes up to the realisation that inflation is becoming more structural and less temporary. That could cause long-term bond yields to push higher and increase the equity risk premium at the same time. If that happens while earnings face an operating margin headwind then the equity market could faces significant trouble. We continue to maintain that under higher structural inflation equities will do better than bonds, but it is important for investors to be overweight companies operating in the physical world and also consider being overweight Europe vs US equities.
2024: The wasted year
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Markets are driven by election optimism, overshadowing growing debt and liquidity concerns. The 2024 elections loom large, but economic fundamentals and debt issues warrant cautious investment.
As US economic slowdown hints at a shift away from exceptionalism, USD faces downside with looming Fed cuts. AUD and NZD set to outperform as their rate cuts lag. JPY gains on carry unwind bets and BOJ pivot.
Amid AI and obesity drug excitement, equities see varied prospects: neutral on overvalued US stocks, negative on Japan due to JPY risks, positive on Europe. European defence stocks gain appeal.
With the economic slowdown, quality assets will gain favour, especially sovereign bonds up to 5 years. Central banks' potential rate cuts in Q2 suggest extending duration, despite policy and inflation concerns.
Commodities poised for rebound. The "Year of the Metal" boosts gold and silver, copper awaits rate cuts. Grains may recover, natural gas stabilises. Gold targets $2,300-$2,500/oz, copper's breakout could signal growth.
