Global Macro Strategy Global Strategy – What drove the rally and can it last?

The S&P 500 forward P/E ratio has risen back to the highs. On the other hand, S&P 500 12 month forward EPS estimates have fallen nearly 15% from the peak on a bottom-up basis.

20 Apr 2020

S&P 500 forward P/E versus forward EPS

Source: FactSet, UBS

The figure charts the percentage of announced disruption to annualized commodity supply for a variety of metals, including aluminium, iron ore, nickel, gold, copper, thermal coal, zinc, manganese, silver, palladium, and platinum.

Financial conditions, Fed liquidity, falling COVID cases can explain the re-rating

The S&P 500 forward P/E troughed at 13x and has risen to 19x, at year-to-date highs. Forward next twelve months (NTM) EPS on the other hand has fallen 11% since the March low and 15% since the February high. Thus, the 28.5% rally from the bottom looks fueled by a 46% jump in P/E. We use existing and new frameworks to assess what drove the P/E swings and respective sensitivities. With the P/E overshooting our implied P/E based on the drivers below, on the way down and up, a further re-rating higher near term looks unlikely with spreads repricing so much and UST issuance coming. A spike in new COVID cases is an asymmetric downside risk, while sustained lower cases could provide some support.

  • Rates and spreads lower (1.2x or 9.2%). The fall in UST yields since the equity lows was  a  ~0.4x  bump  in  the  P/E  in  our  model,  with  Fed  actions  helping  to  lower  credit  spreads a ~0.8x boost, and seemingly taking a worst-case outcome off the table.
  • Fed  B/S  (1.2x  or  9.5%).  The  $2tr  surge  in  Fed  buying  since  mid-March  was  worth  ~1.2x  for  the  P/E  in  our  framework,  net  of  UST  issuance.  The  key  then  will  be  how  much of the coming UST issuance will the Fed offset with continued buying.
  • COVID new cases falling (1.1x or 8.4%). We regressed the level and 5d change in global new COVID cases against the S&P NTM P/E using natural logs since February. Flat-to-down new cases has been a 1.1x boost to the P/E. So a flare up would point to notable downside while a 1/3 decline in new cases as implied by search interest would point to just 0.25x upside. Thus, in our model, COVID cases are an asymmetric downside risk.
  • Positioning/overshooting. Composite equity positioning was 2.5stdev below average at the market low and has risen to 1.1stdev below avg. With the backdrop still uncertain, exposure is unlikely to go above neutral near term. However, "normalization" in cases and thus activity could see eventual overweights with a new cycle and rates so low.

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