Investment banks say the coming third-quarter earnings season could either spell doom for equities and a big rotation to bonds, or else trigger a modest rally into the year-end, depending on how it goes.
Barclays equity strategists said that, despite the magnitude of the recent bond sell-off spooking stock markets, equities are still beating bonds so far this year.
Economic growth and corporate earnings are "what really matters to the fate of equities", the strategists said, with both having remained pretty resilient, allowing equities to rally back despite rising interest rates in the year to date.
It will take a significant stock market sell-off to stop the bond market rout, they added. If economic growth tips over enough to cause a significant earnings rout, "then equity prices will naturally follow and bonds will work as a recession hedge".
Importance of earnings season
But with US economic growth remaining resilient and the labour market showing few signs of cracks, "then the rollover of equities due to fundamentals, rather than rates, is yet to happen" - unless non-farm payrolls say different today.
In light of the strong relationship between equity volatility and earnings volatility, the Barclays equity strategists believe "the evolution of earnings holds the key for equity performance".
So, a positive outcome at this month's earnings season "could set us up for a modest year-end rally" but "arguably, any signs of weakness would spell doom for equities and finally prompt rotation to bonds".
Thus, the near-term risk/reward for equities looks "finely balanced", with the outlook for stocks relative to bonds into next year "looks more challenging to us, with growth more likely to slow than accelerate".
Counterparts at Citigroup said they see a slowing of earnings this year rather than a full-blown recession, forecasting a 1% decline in global EPS growth in 2023 before returning to 9% growth in 2024, versus a wider consensus of a flat performance this year and 11% growth next year.
"Global economic risks generally look more balanced, though downside risks remain," Citi's strategists said in a note today,
"A shallow earnings contraction is more conducive to Cyclical outperformance," the Citi team noted, also reversing their downgrade of global tech stocks a quarter ago.
Looking at European stocks, Deutsche Bank said in a note yesterday that it expects the earnings season to "start revealing more cracks" in the robustness of company profits.
In the Q1 and Q2 earnings seasons, the market was weak despite earnings beats, Deutsche noted, but this time, equity markets have already sold off ahead of the earnings season.
"We expect the impact of disappointing earnings on markets to be rather muted and more sector specific," the German bank's strategists said.
Over at Bank of America the stance remained negative on European equities, along with an 'underweight' view on cyclicals versus defensives.
While the spike in real bond yields has led the Stoxx 600 to decline by 7% from its July high to a six-month low of 440, "this still leaves it 10% above the current macro-implied fair value, according to our analysis".
What's more the BofA strategy team noted that global equities also trade 10% above the macro-implied fair value, based on a similar analysis of PMIs and real bond yields.
They suggest that the market has "looked through" the recent PMI declines, as these have not yet led to a notable decline in actual activity due to order backlog dynamics.
"A renewed decline in real bond yields by itself would likely boost equities, but if this materializes because hard data starts to catch down to the weak signal from the soft data, then it would likely be accompanied by rising risk premia from their low current levels (i.e. wider credit spreads and higher equity risk premia) as well as EPS downgrades, implying further downside for equities ahead, with our macro projections implying a 12% decline in the Stoxx 600 to 390 by Q1."
Meanwhile the dramatic recent spike in bond yields has allowed European cyclical stocks to partly reverse their 7% decline since July, but BofA sees this re-reversing, based on its expectations of weakening growth, widening credit spreads and fading bond yields, hence its underweight stance.
"Value versus growth stocks have benefitted from rising bond yields, but are vulnerable to a rates reversal, with our expectations for lower bond yields implying scope for 10% underperformance for value versus growth."