Citi: Storm or rally? What will the increase in Fed interest rates bring to European stocks – The 15 securities that will be launched

Her Eleftherias Kourtali

Central banks are now more concerned about inflationary pressures than growth risks. Citigroup in today’s report examines the possible implications of the tightening of monetary policy on European stocks as well as the impact of higher long-term returns on the stock market, while identifying the big winners and big losers of this change in central bank policy landscape.

Citi economists see the ECB slowing the pace of PEPP asset purchases in the first quarter, before the program ends in March. They also expect the central bank to reduce asset purchases under the APP to 40 billion euros / month in the second quarter, to 30 billion euros in the third quarter and to 20 billion euros in the fourth quarter. As it moves away from asset markets, the ECB is moving towards normalizing its policy, even if interest rate hikes are likely to begin in 2024.

For the Fed, the accelerating decline in asset purchases to $ 30 billion / month opens the possibility of raising interest rates in March, according to Citi. At present, US bank economists expect the first increase in June, with a total of three increases in 2022.

For the record, Citi points out that the last rise in ECB interest rates was in 2011, while the Fed raised interest rates 9 times in 2015-2018.

In the absence of possible ECB interest rate hikes in the short term, Citi is examining the performance of European equities around the Fed’s last three increases. In general, the pan-European Stoxx 600 index rose before the Fed’s first increase.

European stocks then struggled for the first three months, but ended up strengthening by an average of 10% after one year. For the latest interest rate hike, Citi is taking into account the 2016 hike as the start of the Fed tightening cycle. The Fed raised interest rates once in 2015, but waited 12 months with successive increases, given the Chinese slowdown, the end of a super commodity cycle and Brexit.

Citi then examines the performance of the sectors in the European stock market after the Fed’s first increase. History has shown that cyclics outperformed defense by 10% in about 12 months after interest rates were raised.

The impact of a shift in the US interest rate cycle on European equities will be greatly affected by the “response” of the bond market, adds Citi. The start of a tightening cycle of the Fed or the ECB is usually associated with higher yields on 10-year bonds. Indeed, Citi strategy analysts expect a modest rise in long-term returns in 2022, both in the US and in Europe.

Higher US nominal yields favor cyclical industries in Europe

Citi analysts expect US 10-year bond yields (now at 1.6%) to rise to 2.25% in 2022 due to persistently high inflation and declining QE.

The European banking, car, insurance, travel, leisure and energy sectors have the highest positive correlation, ie they tend to outperform when bond yields increase. Health, personal care, utilities and food and drink have the highest negative correlations. Overall, the cyclics tend to outperform the defenses when bond yields move higher, Citi concludes.

Higher real returns in the US push the rotation to “value”

Citi analysts estimate that most of the increase in nominal returns will reflect the increase in real returns (ie inflation-adjusted returns). They expect US 10-year real interest rates to rise to -0.25% over the next 12 months (from -1% now).

Since 2018, real returns have been closely linked to the performance of “value” stocks versus “growth” stocks in Europe, the US bank said. Lower real yields used to mean higher yields on “growth” stocks, but rising real yields could lead to a shift to “value” stocks in 2022. This could benefit the UK stock market against mainland Europe given the larger slope. to the “value” sectors.

In general, higher real yields will help “value” outperform “growth” in the European market. Energy, banks and the insurance industry are performing well when real returns are rising. Real estate, utilities, luxury goods and technology are underperforming.

Real yields are the main “lever” of valuations

Real returns are also a major lever in stock valuations. Nearly 80% of European p / e indicators can be “explained” by the level of real US returns, as Citi points out.

It seems that the increase in real returns in 2022 may put pressure on some sectors in Europe, especially those whose valuations are more expensive. Luxury items could be vulnerable, along with technology. Other vulnerable industries include personal care, chemicals and industrial products. Sectors will be less sensitive to higher real returns.

As Citi points out, if lower real yields have historically contributed to the re-rating of many of Europe’s most expensive sectors, what effect would higher real yields have had on their p / e? If real odds move from the current level of -1% to -0.25%, Citi estimates that luxury goods will fall from the 33x p / e today to 26x and technology from 29x to 25x. However, they are not expected to have a significant impact on the overall market level, he concludes.

In this context, Citi identifies the winners and losers in the European market, from the change of monetary policy.

The 15 stocks in the table below tend to perform very well when both nominal and real yields move higher, as Citi analysts expect for 2022.

In terms of stocks that receive a significant “hit” in an environment of upward nominal and real returns, it’s the following 10, mainly from the most defense sectors, with real estate having a strong presence: