Easing of monetary policy by the Federal Reserve could lead to lower bond yields, implying upside for quality and growth stocks in Europe, Bank of America (NYSE:BAC) strategists said in a Friday note.
However, the central question on this matter is whether the Fed will cut rates out of choice or necessity, BofA points out.
If the Fed begins cutting because inflation is under control, this could provide a boost to equities by reducing the risk-free discount rate, particularly benefiting growth and quality stocks.
“While some argue that the bond market is already pricing in a recession, this nonetheless leaves it discounting a Fed Funds rate that remains above neutral over the next three years despite increasingly clear signs that the post-pandemic inflation shock is fading,” strategists wrote.
“This suggests that even in this scenario there is scope for a further dovish shift in Fed expectations and, hence, lower real bond yields.”
On the other hand, if the Fed cuts rates due to a weakening labor market, the outlook becomes more complex. In this scenario, rising equity risk premia could outweigh the benefits of lower bond yields, leading to a potential drag on the market.
BofA’s team believes that the second scenario is “more likely,” despite the ongoing ambiguity in the macro environment. The bank highlights that key indicators, such as small-business hiring intentions and the historical lag between changes in the Fed Funds rate and unemployment, signal a likely increase in the unemployment rate in the near future.
“This leaves us negative on European equities, with a projected 13% downside by Q2 next year,” BofA’s note states.
Within this, strategists recommend positioning portfolios for declining bond yields, which they believe will benefit quality stocks and growth over value.
This, alongside expectations of wider risk premia, also points to more upside for defensives compared to cyclicals, as well as downside for financials. “That said, we like cyclicals hedges that have pulled back meaningfully and tend to benefit from lower rates (semis, luxury and chemicals),” analysts added.